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Week Commencing August 25, 2014

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This week we look at the following topics:• How to trade the Energy Markets• Brent, WTI and Natural Gas• Gold to Oil ratio

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Last week we spoke about the alternative sources of energy and outlining how the traditional sources – coal, oil and gas – are still the key growth contributors. We spoke about the slowdown in nuclear energy post Fukushima. There is a lot of noise out there in the market that emerging alternative sources of energy are enough of a threat to put downward pressure on oil prices in the short term.

Alternative sources of energy are important in the future management of global resources and sustainability but they are still not at a level adequate enough to completely compensate or even threaten the demand for conventional sources of energy – particularly as the developing world starts to increase its per capita consumption of oil, gas and coal.

Invast provides access to three key energy instruments as quoted on the MT4 platform – these are Brent Crude, WTI Light Crude and Natural Gas Futures. To find out the exact specifications of each instrument, refer to the Invast website which shows margin levels, times and other important information. Click here to view the commodity market information sheets.

We’ll run through each of these energy sources here:

• Brent crude: Brent Crude is extracted from the North Sea, and comprises Brent Blend, Forties Blend, Oseberg and Ekofisk crudes. Brent is the leading global price benchmark for Atlantic basin crude oils. It is used to price two thirds of the world's internationally traded crude oil supplies.

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Brent blend is a light crude oil (LCO), though not as light as West Texas Intermediate (WTI). It contains approximately 0.37% of sulphur, classifying it as sweet crude, yet not as sweet as WTI. Brent is suitable for production of petrol and middle distillates. It is typically refined in Northwest Europe.

• WTI Light crude: Also known as Texas light sweet. This grade is described as light because of its relatively low density, and sweet because of its low sulphur content. It is the underlying commodity of Chicago Mercantile Exchange's oil futures contracts. WTI is lighter and sweeter than Brent, and considerably lighter and sweeter than Dubai or Oman. An API gravity of around 39.6 and specific gravity of about 0.827.

• Natural Gas: Natural gas is a hydrocarbon gas mixture consisting primarily of methane, but commonly includes varying amounts of other higher alkanes and even a lesser percentage of carbon dioxide, nitrogen, and hydrogen sulphide. Is found in deep underground rock formations or associated with other hydrocarbon reservoirs in coal beds and as methane clathrates. Natural gas is quoted per 1000 MMBtu (British thermal unit).

A common question among traders is why the price difference between Brent Crude and WTI? Although most Brent is destined for European markets, it's already used as a price benchmark for other grades. For years, the price differential between the two has only been a few dollars. Every now and then, a shortage could push the price spread wider, but the divergence has been more drastic since 2010. The differential is currently at around $9-10 per barrel.

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Before August 2010, WTI would actually cost more than Brent since it was a better quality of crude. But there were two things that changed this long-time relationship. The first was that Brent became far more used as a benchmark in most regions of the world. The second was the growing situation at Cushing, Okla.

Cushing is where the WTI daily price is pegged. It is the single largest confluence of crude oil pipelines in the country. That presented a problem: There was consistent inability to move volume out of Cushing, creating a giant glut. In turn, that glut depressed the price of WTI even more. As a result, Brent priced at a premium to WTI for each daily session since August 16, 2010, except one.

With this in mind, our preference is to stick with the Brent crude price as the main trading instrument but we have no grievance with those who wish to trade the spread between the two or WTI on cheaper comparisons. The upper hand given to Brent also tended to exacerbate its price volatility resulting from geopolitical events.

The Arab Spring, Iran, Syria, Ukraine, unrest in Venezuela, and saber rattling from China all magnified Brent’s price given its closer connection to the broader markets. As it stands, Brent remains the standard for European usage, while the continent is far more dependent upon imports from precisely those same areas where unrest has been on the rise.

Therefore our overall bullish conviction for oil as expressed by our thoughts throughout the past three weeks has greater relevance to Brent crude as opposed to WTI. Over the medium term we see Brent again testing the US$115 per barrel range where it will meet very stiff resistance.

As global inflation starts to ramp up and the US eventually increase interest rates, we feel that the production cost profile for many large producing nations (also impacted by the geopolitical challenges which we have written about this month) will start to put upward pressure on global pricing. We’re not sure where the price will stabilise in the short term but we feel comfortable with the US$100 per barrel price floor for the time being. We will evaluate and update should this change.

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In our Invast Insights report published on 30 June 2014 – our first note highlighted “Brent crude vulnerable at US$115 per barrel”. In that report we wrote “Brent price is now just below US$115 per barrel which I think is a major inflection point. We either come down or massive up from here, make no mistake about it. I doubt that the Brent price will just sit and consolidate at US$115. It seems as though the US$115 level has failed in the short term. We saw a large pullback from here. Make no mistake, we remain bullish about the medium to long term oil price but we don’t ignore the short term movements either…”

Image: Brent crude weekly chart via Invast MT4 platform, lower indicator showing oversold. Arrow illustrating strong resistance levels.

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As a trade, we will be talking about a long position in Brent during our webinar on Tuesday 26 August at 6:30pm. The levels we would be inclined to take are a stop loss at US$100 per barrel with a potential target range somewhere in the order of US$115 for a strong risk to reward ratio from current spot prices of around 12:1. There will be some very strong resistance at around the US$106-109.50 levels in the short term but our though convictions are more long term.

In terms of natural gas, we don’t have a strong conviction on price at this point. Natural gas prices have been volatile in recent years, at times collapsing to levels below US$3MMBtu before recovering over the past year or so, currently at US$3.73MMBtu. The level of increase in US natural gas production is very significant and the market is still yet to develop a feel for the demand and supply relationship. This to us is very different to oil and Brent. Often the growth in US natural gas production is distorted incorrectly with growth in US oil production and the demand and supply relationships are intertwined, usually unfairly. For this reason we remain impartial to natural gas prices and have no strong conviction on pricing either way.

For those unwilling to take a firm view on the Brent crude price, we suggest having a look at the Brent crude to gold ratio which we will again be talking about in the webinar this week. We have spoken about this ratio previously and so while this isn’t something new, it is tied in well with the whole energy and gold theme.

The gold to oil ratio is a very popular trade among veteran traders to see the relationship reverting back to the mean average somewhere near 15x. The ratio calculates how many barrels of oil an ounce of gold can purchase. We can take the relationship back more than 60 years through the following chart to see the peaks and troughs brought about by wars and other geopolitical events which caused a shock to the relationship.

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Image: Gold to oil ratio since WW2 via www.macrotrends.net

One thing to note on this ratio, this is a very medium to long term type of trade. It should note be taken with an immediate time frame. At 15x the current Brent crude price, gold implies a price at US$1,540 per ounce. Using West Texas crude as the base measure, gold implies a price of US$1,410 per ounce. The 15x multiple isn’t an exact or precise measure but it is merely a level which the chart above suggests is the post-war average. The impact of higher oil prices has a huge flow on effect on global inflation and this is what gold bugs thrive on. The correlation between both is uncanny.

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The other way of looking at this relationship is to take the inverse. The current gold price of around US$1280 an ounce on a 15x Brent ratio would imply a Brent price of US$85 per barrel which is where some bears see the price falling to. We disagree because of the fundamental reasons which we have outlined this month but we are also prudent enough to have a tight stop loss at US$100 per barrel with US$85 the next major support level if Brent continues to slide. This should serve as a medium term floor level, something we will discuss again in the webinar.

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Energy outlook: Join the webinar to discuss these points

Invast Insights editor and contributing author Peter Esho will summarise the August outlook guide for energy markets in this exclusive webinar. Esho is a regular contributor on CNBC, Bloomberg and host of ‘Your Money Your Call’. In his webinar he will outline:

True or False? What’s happening in the USA energy marketHow the impact of the Middle East problems will impact oil supplyAlternative energy options, what are theyHow to trade the energy markets on Invast MT4 platform

Peter’s webinar will cover both the fundamental and technical outlook going forward plus the key drivers to look out for and is expected to fill fast. Q&A will be open straight after the webinar. Register now by visiting CLICKING HERE.

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Go to www.invast.com.au/insights to get a complimentary 4 week trial and receive the latest insights as they are published to our live clients.

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