Demand vs. Speculation and High Oil Prices: Apples and Oranges or Fruit Salad?

 |  Includes: DBO, OIL, USO
by: Hard Assets Investor

This week's news blotter features two views on recent oil price surges, from The Washington Post and Fortune Magazine.Apples and oranges.

The Apple

The Washington Post article, Oil's Recent Rise Not As Familiar as It Looks, points to speculators as the driving force behind oil's recent climb towards $100 a barrel. Historically, the markets were the place that "big oil" and others directly involved in the industry went to conduct business. Contracts were made for actual physical delivery of oil, with futures used to lock in prices, costs and profits for their businesses. Yes, "outsiders" played the market, but these were seen as sources of liquidity, and not really large enough players to influence price movements. Oil prices moved in response to geopolitical conflict and real or imagined physical shortages. As the market has matured, this no longer seems to be the case. This is the angle the WaPo is echoing:

"Instead, traders who treat oil like any other commodity are widely thought to be driving prices upward, bolstered by a weak dollar and money flowing out of stock markets and other investment vehicles."

Call it the popularity of commodities or the new ETFs that make trading them easier than ever, oil is becoming less of an elite trading vehicle for actual oil market participants and those who make markets, and just another asset class for speculation, says the article.

If this is true (and even OPEC is on the "it's all about speculators' bandwagon,") then perhaps we are truly looking at an oil bubble. If the prices are being run up without regard to underlying supply and demand issues, and it is the speculators that have the bit between their teeth pulling oil to $100, then the pop should be coming soon. Remember, shortly after "everyone" was in tech stocks, those tech stocks soon became worth a whole lot less in a hurry.

Adding fuel to the speculator fire: The Financial Times is reporting today that call options have actual open interest as high as $250 a barrel. That's Katie-bar-the-door territory. Sure, someone might be just playing the curve–buying calls so far out in the future and so far out of the money that the market gets inefficient, and there's an opportunity to play a pop. The 2010/$250 options, for instance, ran up from 5 cents to 16 cents in just a few months. On the other hand, you had to find both a buyer and a seller in an illiquid option in order to pocket that. We're talking heavy-duty speculator land.

The Orange

For Fortune’s part, The New Math of Oil looks at the assumption that high energy prices are always bad. The interesting quote comes from Daniel Yergin, chairman of Cambridge Energy Research Associates:

"This is a demand shock, not a supply shock. What's causing it is the extraordinary economical growth of the past few years."

This is a horse of a different color. If the high prices are primarily a response to a strong global economy (think China and India's rapid growth) demanding more oil, support for these higher prices should be more stable than a fear reaction to conflict or some speculator bubble. Evidence seems to support the demand shock idea– stock markets around the world are still healthy, even as oil prices continue to rise. If the high prices were caused by supply issues, Fortune posits that we would be seeing bad news to come, like a recession.

Fruit Salad

Whatever is happening–speculator influence, demand shock, supply constraints–price pressure seems to be continuing. If it is the speculators, the question becomes: Will they actually push the price so high that demand drops as the law of supply and demand would suggest? If the bubble bursts and the price drops, would demand rise? If it is a demand shock, will demand continue to grow in the face of high prices, or will we see a slowdown in demand, and therefore a slowdown of the global economy? Will some event in the Middle East make all of this discussion a moot point by strangling supply, sending oil skyrocketing even higher?

We do not operate in a vacuum, and the real reason behind price behavior is obviously a combination of the above. There are clearly those who think the only way to go is still up. It's important to ask the questions and look behind the "what" of a price movement to the "why,” so you can look forward. Notice I didn’t say that you'll be able to predict what is going to happen next. Because when you mix apples and oranges, sometimes you get fruit salad … and sometime you just make a mess.