Irrational Pricing in Crude Oil

Last summer I showed the inflation adjusted price of crude oil - below is the updated chart:

Source: Chart of the Day

It really puts last year’s crude oil bubble into proper perspective. Not only was it about 30% more intense than the 1970’s oil shock, it towers over the other price spikes we’ve seen.

What is even more peculiar is that this bubble was entirely artificial. It was not due to any geopolitical rationale, nor was it because of a supply/demand imbalance. It was entirely concocted out of thin air by large traders.

The world economy was fragile because of excess credit and speculation. Oil was the first domino to topple and knock the others down by slowing down the economy to reveal the rot under the surface. If it wasn’t the main cause of the worldwide economic slowdown, it was definitely one of the leading reasons for its severity. Although the connection needs no explanation, you can clearly see that every single recession was either preceded by or coincided with a large increase in the price of oil.

The crazy part of all this is that no sooner had the dance ended that the same players started dancing all over again. Hedge funds and large players are once again stampeding back into crude oil and commodities. After bottoming in February 2009, crude oil has doubled in price! That’s a little over 3 months ago!

And once again, there is absolutely no rationale for such a move. What? Have we suddenly lost our previous reserves of oil? is production somehow curtailed by war? or geopolitical unrest? or perhaps the market believes that the world will suddenly consume much more oil than it did before the recession?

As traders, we don’t really care whether there is a legitimate move or manipulated by deep pockets. But at the same time, if you’re going long and letting the trend take you for a ride, just remember the difference between turkeys that get caught up in a tornado and eagles. One comes down to earth with a thud. The other soars majestically, landing at a time and place of its choosing.

Comments

[BigJake:]

consider this turkey caught up in the storm for now...

Jun 05 11:54 AM

[blu:]

Legitimate or manipulated???

Time to remove your blinders and see the markets are working just as should be expected. Hedge funds and large traders are part of the market. It is futile to cry about their strategies. Try to take advantage of them.

There are going to be huge swings in the price of crude oil as predicated by peak oil.

Traders have to look beyond the short time inventories that have built up to less than ONE DAY of daily oil consumption. There no longer exists enough storage capacity to rationally effect the longer term oil price. The world is simply burning so much that storage is a non-player. Those evil "hedge funds and large traders" are seeing through the fog.

Jun 05 12:06 PM

[Prudent Man...:]

Mr. Market will do what it wants to do? To think it is an accurate "discounter" is buying into the Wall Street, and their lap dogs in the media's, myth.

Just looking at the chart and no rational person can make sense of it. All markets, to a degree, are manipulated. That is why you, even if you are a short-term trader, need fundamentals to favor your position if you want to stay in the game for any period of time.

Jun 05 12:19 PM

[jamookey:]

They aint finding any new major fields.Maybe the author should study crude before he makes any more dumb remarks.Whether the economies of the world recover this year or next,crude is being depleted.quickly.We all saw how the fast the world will ramp up consumption.Should we wait until this bozo says..
'well I guess I was wrong.."He is probably short oil and is getting killed.Should we also stand around with our crying towels?

Jun 05 01:18 PM

[sduyck:]

oil crashed last summer

it will again ..ask any man on the street...they cant pay or refuse to pay 3$ a gallon for gasoline

Jun 05 02:00 PM

[jamookey:]

SDUYCK,They have no choice.They will pay3,4,5 who knows how high it will go.What do you suggest that they quit their jobs?Stop taking their kids to soccer games?Buy fuel efficient vehicles?None of these things are going to happen.And what you forget is that the Chinese need billions of barrels of oil just to build all the roads they are planning so their citizens can do the same.Watch.

Jun 05 02:58 PM

[JeffDB:]

If the "speculators" are correct, (ie. that prices are headed up over the next few months) it would seem to me that they are actually doing us a favor. Increasing the prices now will help to both boost production, or keep it from falling further, and to encourage conservation, more efficient vehicles etc. while at the same time boosting reserves because of the contango effect.

If consumption actually goes up considerably those extra reserves can help ease any potential shock, as would more efficient vehicles, etc. and the supply projects that had continued on because of of the higher prices, rather than having been canceled because of the lower prices.

Jun 05 04:25 PM

[JeffDB:]

"What is even more peculiar is that this bubble was entirely artificial. It was not due to any geopolitical rationale, nor was it because of a supply/demand imbalance. It was entirely concocted out of thin air by large traders."
-----
I'm not so sure about that. It seemed to me at the time, particularly early on that even as prices continued to rise significantly, demand also continued to go up. Even when US demand finally started to drop, worldwide demand still continued upward.

See:

EDITORIAL: Peak oil, not speculation
www.energycurrent.com/...

..Let's re-wind the clock and recall the events of the time.

After many years of solid growth, oil production plateaued in October 2004. Regardless of the price level, the oil supply simply stopped responding, and from then on, the world had to make do with broadly flat supplies. Ordinarily, the expansion of the world's economy would be accompanied by increased energy consumption and an inelastic oil supply might have been expected to hinder economic development. It didn't. In the four years to mid-2008, the world economy expanded by 18 percent. The global economy boomed, even without new oil.

However, this came at a price. In the absence of oil supply growth, demand accommodation was required. This was achieved by secular prices rises averaging 25 percent per annum from 2003 to the end of 2007. In other words, the price of oil went up, and this constrained consumption by causing the marginal consumer to drop out of the market. This proved a workable solution for a time, but the global economy could not sustain 25 percent annual price increases indefinitely, and by the second half 2007, the situation was becoming critical. Consumption was being maintained by continuing draws on inventories averaging 1.4 mbpd, and virtually every producer, with the possible exception of the Saudis, was running flat out. By early 2008, even the Saudis were throwing the kitchen sink at the market - all to no avail. On paper, it looked like a peak oil nightmare.

..Still, as inventories continued to fall until May 2008 and all the oil producers were running at full output, the case for market manipulation at that time is hard to make. Indeed, the market was in backwardation most of this time. In backwardation, futures prices are lower than spot prices, the equivalent of the market saying, "Well, prices are high now, but they'll be lower later." The market - those very speculators - believed that oil was over-priced but was continually surprised as demand kept pushing up prices.

Prices did ultimately fall, but not because the supply situation eased, nor because speculators fled the market, and not because inventories were released. Prices fell because the global economy collapsed. ...

Jun 05 04:50 PM

[Ferdinand E...:]

Spectators, traders and all the rest of the paper suppliers and demanders can do their thing, but the oil price they might create must be verified in the physical market. As long as the OPEC countries are prepared to reduce their supply if the oil price is not to their liking, a downward price trend is out of the question. Try reading the brilliant article by Dave Cohen in '321 Energy"

Jun 06 09:41 AM

[robert essian:]

While you're scratching your head 42% of world oil and gas rigs are laying in the grasses. Better than 50% right here. Fields are depleting 6 to 9% per year. The populations of the world are growing, and we want to drill the deep waters, and the Northern ice sheets (melting), and use corn (and LNG, etc) to supplement oil because the world produces 74 million a day and we need 84. Add this up, and it looks to me that we are in for a world of Doo Doo...Peace...Robert Essian

Jun 06 11:06 AM

[robert essian:]

PS: Jim Kingsdale represents all that could be explained about oil. His site is a must visit, a daily visit...Peace

Jun 06 11:09 AM

[searcher:]

Markets will fluctuate. What is your pain threshold? How long can you endure? Invest accordingly.

Jun 06 02:28 PM

[Tony Daltorio:]

Apparently the author did no research before writing the article or else he would have understand how supplies are dropping and future supplies are greatly imperiled by the financial crisis and cancellation of so many projects. My guess is also that the author has never heard of emerging markets and their increased demand for energy. Probably sits around all day watching CNBC.............

Jun 06 03:14 PM

[ArtfulDodger:]

Babak wrote: "if you’re going long and letting the trend take you for a ride, just remember the difference between turkeys that get caught up in a tornado and eagles. One comes down to earth with a thud. The other soars majestically, landing at a time and place of its choosing."

Excellent advice. Now, let's hope that we can discipline ourselves to make a soft landing with a little extra in our pockets.

Jun 06 11:08 PM

[harammph:]

The IMF has issued a statement that it is the process of pursuing an SDR to replace the US as the world's primary reserve currency.

Lets see what this piece of news does to oil and commodities in general.

I'm really tired of all the platitudes about the US doing this or that.

The US Economy has gotten worse. The Economies of others have gotten Better at the Same Time. It Seems Obvious to me, "They Do Not Need Us".

They need commodities for expansion but "the USA doesn't have any to give" other than food.

Lets return to the Good Old Farming days, we can be the "breadbasket of the world" again.

Jun 06 11:47 PM

[Diegojames:]

I sold Valero weeks ago. Another management joke. CEO could have bought CNG producer, lithium battery producer and lithium mining shares and directed his company to the future.

My mining shares -TCK , Stillwater etc are OK. Commodities producer share 's will hold value unless some must sell them to raise cash. China's auto buyers will buy gas from BP and China Petro companies. USA integrated oils will decline slightly as hybrids are mandated on us.

Oh yes, Chinese like some Coca Cola and hamburgers. buy KO and YUM. I own KO.

Jun 06 11:59 PM

[one eye:]

Diego, you miss a point. Only xyz of every Brl of oil can be distilled into Gasoline/heating oil/sludge.

You can't expect even State of the Art refineries to meet the demand that will be coming out of the existing supply of oil. More oil will have to be used to meet Gasoline demand, ditto diesel.

The squeeze has been on for sometime. Brent never reached the low WTI levels. The demand from China/India will take Brent higher. We still Import much more than we produce. Chindia has to slow down to accomodate us. I do not see this happening.

Jun 07 01:41 AM

[The Greates...:]

Oil and gas were manipulated by the future traders last year and now the refineries are cutting back to reduce gas at the pump and drive up the price. I think the summer driving season will be driving to the back yard and playing in the kiddie swimming pool.
They are an estimated 10 million Americans out of a job today, Americans are driving less then they have since the 1950's.
Fluctuations and hyperactive are words being used for manipulation and control in the oil industry. Plenty of crude today, around a 19 year high, and yet the price of gas is on the rise.
We can all thank Phil Graham for that.
So how about something original lets regulate the futures energy commodities market? Or better yet, free us from the use of oil altogether? The oil industry as a whole made around $476 Billion in net profit over the last 6 years, the pulse of the worlds economy is under the thumb of 13 OPEC nations and 5 major oil companies. Is this the legacy we want to leave our children and grand children?

Jun 09 04:11 PM

[harammph:]

The Greatest: I blame You for this mess. I blame you because you represent the People that want to Blame eveyone but refuse to Take any Blame themselves.

No New refineries, Nuclear Plants, Energy Policy.

That and "Not in my Backyard", that's You through and through. Its Always Everyone else's fault.

Jun 13 01:04 AM