Crude oil prices may be headed lower

The price of crude oil has fallen nearly 65% from its peak in August 2014. This much of a decline would normally argue for a rebound. However, as many have learned, the rebound has yet to occur. This has left us with the question: Where are oil prices headed? To find the answer, we’ll examine the relationship between risk in the oil industry and oil prices. Clearly, this relationship is undeniable.

Oil & Risk

When investors need to assess risk in the stock market they turn to the CBOE VIX. This VIX measures the expected volatility or fluctuation in the S&P 500 Index over the following 30 days. There is a similar statistic with oil, which is appropriately named, the Oil VIX. The Oil VIX measures the degree of risk in oil prices and is often a good indicator of near-term price movements. In short, when the Oil VIX rises, oil prices tend to fall and vice versa.

The Oil VIX began May 10, 2007 and has a long-term average of 36.58. However, this may be skewed to the upside due to the highly-speculative run up and subsequent collapse of oil prices in 2008. Hence, a more normal long-term average is likely much lower. Where’s the Oil VIX now? At the close of business September 22, 2015, the Oil VIX was at 48.90, much higher than its long-term average. As I write this, one day later, the Oil VIX has risen to 52.10 and oil prices have fallen an additional 3.50%. Where are oil prices headed?

The following chart illustrates the relationship between the Oil VIX and oil prices. I have added a few arrows to show how oil prices have fallen when the Oil VIX rises. Note the especially strong relationship between the two.

An elevated Oil VIX is an indication of greater volatility (i.e. risk) and a higher potential for additional price declines. So far this year oil prices have traded between $38 and $62 per barrel. When you consider the U.S. Energy Information Administration’s estimate that production will exceed consumption through the end of 2016, there is a strong argument for additional price declines. Of course, this assumes the EIA figures are accurate.

No one can say with certainty where oil prices will go from here. This is primarily because of factors outside of supply and demand that impact its price. Therefore, in the absence of a conflict, terrorist attack, natural disaster, or other unforeseen event, I believe the price of oil will remain range-bound and possibly fall even further. I’ll keep you posted.

http://www.forbes.com/sites/samanthasharf/2015/09/24/are-millennials-delusional-half-say-theyll-cover-the-cost-of-college-for-their-kids/