opec braces for sharp drop in oil prices

BloggingStocks | Why is OPEC expecting a sharp drop in oil prices? First, much of the rise in oil prices has followed the rally on Wall Street. Investors reasoned that higher stock prices means that business is doing better and hence a need for more oil, and prices rise.

Not so fast. Business demand for oil is weak, and the consumer got clobbered by the recession and is holding back spending money. So the classic relationship between the stock market and oil that investors follow is not there this year.

The Wall Street Journal is reporting that stockpiles are at a 24-year high. Distillate demand for gasoline and diesel fuel dropped by 15%. Refiners have cut back production to 85.8%, from 87.9% the previous week. Distillate stocks surged to 160.5 million barrels, the highest level since 1985.

The price of September crude closed at $68.05 per barrel on Friday, up 89 cents. The futures contracts for crude in are a contango. What is a contango? It is a futures market where the prices for distant contracts are higher that those for nearby delivery. For example, the September futures contract closed at $68.05 per barrel while the December contract closed at $72.52 per barrel. This sets up a huge profit margin for oil traders. They simply buy the cash crude oil and sell distant futures contracts against them. The profit spread between September and December is $4.47 per barrel. Figure that profit on say 1,000,000 barrels.

The effect of these factors are that the buyers of nearby oil have no more room to store it. They are using tankers and barges and running out of room. So now we have a glut of oil. OPEC sees this and is bracing for a sharp drop in prices.

This is also how banks are racking up huge profits. They are borrowing money at 0.25% from the Fed and lending it out longer term at much higher rates to businesses and consumers.

Would you sell oil contracts at these levels?