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A barrel of oil is not a piece of paper (like a stock certificate) or a bunch of ones and zeros in a computer somewhere (like money). It takes up space. It is real. It's a commodity.

The price of stocks and bonds is determined, just like the price of everything else, by supply and demand. Financial assets differ from commodities, however, in several significant respects. For one, financial assets can simply be created out of thin air. Companies can issue almost limitless shares of stock, as we saw in the Internet IPO craze. The creation of vast new supply with almost no effort dramatically alters the supply-demand balance. We all know what happened to almost all of those Internet stocks. Kaboom!

Commodities are different. Commodities have to be looked for, mined, farmed, drilled, grown, harvested, or pumped out of the ground and then they have to be shipped to distant locales where they are eaten, burned, hoarded, or otherwise disposed of. In the short run, additional supplies of commodities are very difficult to come by, absent significant stockpiles or a lot of excess capacity waiting to come on line.

Most importantly, to influence the spot price of a commodity, except in the very short term, a speculator or investor has to take physical delivery. Virtually all serious academic studies of speculation in commodities markets, and there aren't many, have concluded that speculators have limited or no long-term effect on prices and that speculation actually reduces price volatility. Speculators are like market-makers. They provide liquidity to the market and maybe take a position here or there, to little net effect.

Some commodities, of course, are more easily accumulated than others. Gold, for example is easy to purchase and store safely, albeit with some carrying cost. Individuals and institutions who take physical delivery of gold, or who buy gold in allocated storage, ultimately do affect the price of the commodity.

Other commodities, and oil is a very good example, are difficult to store in quantities that are at all significant relative to global daily consumption. Total US stockpiles of crude oil (excluding the Strategic Petroleum Reserve) are about 350,000,000 barrels. But this is only 17 days worth of consumption. A very large increase of current stockpiles is impossible without the construction of vast new storage facilities. With US crude oil consumption already down around 10% due to the economic downturn, who would build such facilities? Hedge funds? Right.

The price of crude oil is determined in two places. Demand is determined at the pump. Supply is determined at the wellhead. That should seem obvious, but it isn't to investors who have cut their teeth trading purely financial instruments. Granted, futures contracts are financial instruments, i.e. pieces of paper with nearly infinite supply and with significant demand coming not from refiners desiring crude oil for delivery at Cushing, OK, but from institutions looking to profit from the increase in the price of oil. But institutional investors, including hedge funds, don't want, don't need, and can't store crude oil (apart from the occasional tanker here or there). So, they have to close out their positions. Their demand is transitory and always comes back as supply in the front month or earlier. Ultimately, financial institutions just don't matter to the long-term price of oil, no matter what the self-styled "Masters of the Universe" want you to believe.

What does this mean for investors interested in energy plays? It's simple. Look at the fundamentals. Global crude oil production has been unable to break the 74 million barrel per day barrier since 2005, even with the significant price appreciation in oil that has occurred since that time (in 2005, oil was "expensive" at $40 a barrel, remember that?)

There is little reason to believe global production will break the 74 million bpd level now, almost seven years later. Where will it come from, Saudi Arabia? Where were they in 2008? Uh, no answer. Will Saudi Arabia ever produce 9.5 million bpd again. Who knows? They didn't produce more than that in 2005 or in 2008. Why now? There just isn't any acceptable, rational answer to that question.

Meanwhile, demand in China was up an astonishing 19% year over year in December according to the IEA. OECD demand is up as well with the nascent recovery. Overall, global demand increased 2.4 million bpd in 2010 according to the IEA. If demand increases another 2.4 million barrels per day in 2011 (which seems likely) and there is no or little additional supply (also very likely), we will have another massive price spike in 2011.

The key point is this: don't worry that hedge funds and other institutions will suddenly get cold feet and bail on the oil trade like they did with Internet stocks and sub-prime mortgages. Oil prices will fall again, but only after the wheels come off the global recovery, likely in 2012. And we aren't there yet.

My recommendation: buy the crude oil and refined product ETF's: USO, OIL, USL, BNO (Brent Crude), and UGA (wholesale gasoline), and the oil-service stocks (OIH) and exploration and production stocks (XOP). Close to the money options on all these ETFs with enough time to allow the price spike to happen, like say sometime next year, will very likely produce significant positive returns.

Most of all, don't worry about being an "evil speculator." If you want to affect the price of oil, buy a Suburban, or better yet, just blow up the Ras Tanura processing facility in Saudi Arabia, which handles five million barrels a day of the stuff (just kidding, of course.) Now, that would be evil.

Disclosure: I am long XLE, USO, USL, XOP, GLD.

Source: The Myth of Speculative Demand for Oil