Although I hated you for pushing up oil prices causing me pain at the pump, I forgive you because you're on my side now, pushing prices lower and relieving my pain. (See my closing comments for more on this).
Talk about a trade “unwinding"! The darling investment of the year is getting trounced, just at the time it was supposed to rise to $200 per barrel. And just as the media talking heads could blabber about nothing else.
Let's look at the numbers. Oil Futures hit a high of just under 146 on July 14 of 2008. Last Friday the contract reached 115. A percentage decline of 20%
Let's go back to the beginning of the year to get whole story. On Jan 1st this year, the black stuff traded at 92. If we calculate the rise to 115, the price is up 27%. That's a very good rate of return, wouldn't you agree? 27% in 8 months?
Those lucky (or savvy) investors who owned oil in January are up 27% -even though they were up 57% at one point. Still, I'm sure you agree, a very nice profit. So, why not take that profit and go home. I would do that, wouldn't you? Well, that's exactly what they're doing.
But there is more to this tale. Not everyone got in at the beginning of the year. As a matter of fact, there are an awful lot of investors and speculators who got in pretty late. I even think there were a slew of investors (suckers) who got in right near the high of 145. What has happened to them?
Many, as I will explain to you, have been slaughtered. You see, for many people, investing in oil means purchasing contracts for its future delivery. In order to purchase these contracts, you need only to put up some collateral which then enables you to make your best bet. You use this collateral, say treasury bills, to buy as many contracts as your collateral will allow, generally at a ratio of 10 to 1. 10 to 1 is a very extreme amount of leverage. Because of the danger, it is mostly a game for professionals but a lot of non-professionals get involved because they believe it is a quick road to riches
Here's how you make or lose a fortune. Say you put up enough money to buy $100,000 worth of oil, generally $10,000 worth of collateral. Remember, you don't have to put up any cash, just the collateral. If your contract goes to $145,000 you will have in effect, earned a return of 450%. ($10,000 turned into $45,000). Big investors like hedge funds will make much larger bets because they are managing millions and billions of dollars for clients and need to make larger bets to make serious amounts of money.
I have just described the upside. What if you bought the oil contracts for $145,000 and put up $14,500 (10%) and low and behold, your oil contract declines to $115,000. In this case, your loss is $30,000 ($145,000 - $115,000). This means that in addition to losing your $14,500 you now owe your broker and additional $15,500. The broker will politely and quickly send you a notice at the end of the day demanding you add money, bring in other securities, or else it will redeem your collateral to get its money. This loss of $30,000 is as real as it gets. Multiply this by 100s of millions and you can see why the price of oil has been going down 4 or 5 dollars each day.
Thank you, Mr. Speculator!
So what is the take-away from all of this?
This is a constant theme from me and it ties into 2 important rules investors should always remember.
Rule #1) If a sector or particular type of investment (think internet stocks, real estate) is the topic of continuous conversation on TV or in print (especially magazines like Money) it's too late to get involved. The big money has already been made and you are the guys they're selling to. If no one's talking about it, it doesn't necessarily mean it's a good investment, but you can look closely at it with the knowledge that while the price may or not be high, it's hasn't been driven up artificially by the media.
Rule #2) Know what you own. Do you really understand the dynamics of investing in oil?
Why is it rising? Why did it rise so much? What are the factors governing the laws of supply and demand? Who are the important players?
One last thought on speculators. . . When the price of oil was rising day after day with no end in sight, there was a lot of talk about limiting the role of speculators in the market. This is a big mistake and here's the reason. Yes, it hurts us when they push prices too high, but we need them to get crushed when the market turns against them. We need the same volatility on the downward move that we had on the up move. We have got to let the free market do its thing. Speculators have their place. They provide needed liquidity into the market- helping to insure that there's a buyer for every seller and seller for every buyer.
I hope this helps you understand some of the characteristics of the investment world and keeps you from making some serious mistakes.
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