Chicken Little and Oil Prices

Includes: DBO, USO
by: John Petersen
Nothing is more appealing to bloggers, financial analysts and investors than the chance to put on a Chicken Little costume, jump on a soapbox and predict huge increases in price of crude oil, the world's most widely used commodity. The complexity of the graphs and charts always makes me smile since oil prices have been relatively predictable for decades, and there are no unseen forces at work that are likely to change the fundamentals.

One of the first concepts every investor learns is the "normal trading range." You take a long term price graph and draw a line that connects the principal highs and then you draw another parallel line that connects the principal lows. Everything between the two lines is a normal range. If you perform the exercise with crude oil prices your graph looks like this.

The undeniable fact we often overlook is that oil prices drive global economic activity. When oil is trading near the bottom of the normal range it tends to stimulate activity. When oil is trading near the top of the normal range it tends to depress activity. When oil spikes out of the normal range things rapidly go to hell in a hand basket.

If you look at a long-term chart for oil prices the normal trading range was basically flat until the late 90s, when Asian growth took off. Since the resolution of the Asian financial crisis, a new upward sloping price channel has established itself and except for the 2008 spike and the 2009 trough, oil prices have consistently stayed within the channel.

Today most pundits are predicting $100 oil in 2011. It could happen, but not without a lot more strength in the global economy. Today, oil prices are clinging stubbornly to the bottom of the price range and I can't see any economic forces on the horizon that will drive them toward the top of the price channel.

My all time favorite discussion of oil prices was a December 20, 1973 column from the late Art Buchwald laying the blame squarely at the feet of the Harvard Business School:

"Almost every sheik now in charge of oil policy for his country was trained at Harvard. Everything they learned there they have put into practice to the detriment of the Free World. The Harvard Business School taught the sons of Arab potentates how to sell oil, raise prices and demand outrageous profits for the black gold they have in the ground. Had these same sons been sent to the University of Alabama, Oklahoma or Texas, they would now be involved in developing football teams instead of putting the screws to everyone."

Regardless of your opinions about the powers that be in the oil industry, they're not stupid and they'll always act in their own best interests. Depressing activity when the global economy is weak is not smart. So while prices may move up or down over the short term, I have to believe they'll stick to the bottom of the trading range for at least a couple more years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.