Wednesday, March 21, 2007

Energy Volatility

There is a stupendous proliferation of trading financial instruments (derivatives and futures) which are based on the actual commodities (oil and natural gas). There are trillions in derivatives being written which carry vast amounts of risk. This financialisation is just in the first inning. The current energy derivative market at $3 trillion could expand up to an $80 trillion market -20 times the market for physical oil and gas. This kind of speculative trading is now heavily influencing the price movements of oil.

To illustrate this, I've marked up a chart of a major energy ETF (XLE). There have only been two crises which had the potential to affect markets: the Iraq War starting in early 2003 and Hurricanes Katrina and Rita in late 2005. The rest of the time, there was a background noise of "geopolitical tensions". Note how oil moved up with modest volatility until 2005, at which point wild swings in price became the norm. Yet other than the hurricanes - which affected perhaps 2% of global oil production - there were no events in the physical world to explain or trigger such wide swings in price.

I also drew some green lines on the chart to show the long-term uptrend in price, and the diverging downtrends in MACD and RSI. This should give us pause about the sustainability of the uptrend.

Matt Simmon - Is The World’s Energy Supply Sustainable?

Beneath all the price swings lies the issue of Peak Oil. Production is peaking, creating the inevitability that supply will not meet demand in the near future, causing massive price increases.


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