The Big Picture on Oil Prices

The most interesting story so far in 2007 has been the price of energy. Since the beginning of the year oil has moved down to a 19 month low, losing nearly 15% of its value and dragging the entire energy sector down with it. There seem to be a number oof factors pushing oil both up and down. Being that I am an accounting type, I love to build t-charts and list opposites on each side. Let’s first take a look at what is driving oil down.

The real slide started with the warm winter (in most of the country). Natural gas inventories, which influence oil prices, are 18% over historical averages at this time of the year. Another factor contributing to the downward pressure in energy prices has been the rebalance trades in the Goldman Sachs Commodity Index and the Dow Jones AGI. The initial sell off has been compounded by oil prices taking out important technical levels on the way down, scaring the hell out of speculators.

On the macro side, oil has been pressured by the perception of an economic shift to a growth phase in the economy. Although the other factors are mostly likely transitory, the rotation out of tangible assets into intangible assets based in the phase of the economic cycle is a real issue. If we are truly moving into a growth phase in the economy, intangibles, specifically tech, should become the new leaders. Of course, if this is the case, we also have to keep in mind the Fed will probably not be lowing interest rates anytime soon and the next move would likely be up.

On the other side of the coin let’s now take a look at what might be pressuring oil prices upward. Here, again, we can take a look at short-term influences such as OPEC’s announcement that they are considering an emergency meeting to discuss more production cuts. Although this is a threat, most people believe that production cuts by OPEC will likely be ineffective because of cheating. According to Reuters, speculators are net short oil futures. This is the first time we have seen this since the beginning of November, which, unfortunately for the speculators, was followed by oil prices moving up, punishing their mass short positions. It remains to be seen if this is an accurate contrarian indicator.

From a technical perspective oil is extremely oversold -- some sort of dead cat bounce is definitely to be expected at this level, even if the sell off is for real. Of course if weather is the factor that started the slide, perhaps it will be the one that ends it, as cold weather blankets much of the country going into next week. Probably the biggest factor is the risk premium on oil. The question we should all be asking right now is "did the supply demand picture ever justify $70 oil"? The answer is probably no. The reason oil traded to $70 was because there was a risk premium.

There is a great deal of saber rattling going on right now between Iran and the United States. Last week the US raided Iranian offices and arrested their officials, sent additional aircraft carriers to the Gulf, and agreed to supply its allies in the Middle East with patriot missiles. Not to sound like a conspiracy theorist or anything, but there are many hundreds of millions of dollars to be made by cartel members by aiding instability with a few choice remarks or actions. I expect the rhetoric to increase in the coming weeks, increasing the risk premium on oil and pushing prices higher.