Oil's Up and Down Ride

Includes: DBO, GLD, OIL, SLV, USO
by: Jake Berzon

The question on many stock market participants' minds these days is how much longer the current rally will last. Most of us are sane enough to realize that the good fortunes bestowed upon us by the markets since March will be taken away again at some point in the not too distant future. The question is only, "when will the good times end?"

Paraphrasing a popular Russian saying: "If I would know that, I would live in Monte Carlo." What I can tell you with much certainly is that for most of us the demise will come just as suddenly and unexpectedly as did the reprieve. And when the markets fall this time, so will the oil prices.

"But what about peak oil?" you ask. It's coming, of course. Supply is not infinite and so, by definition, at some point in the future worldwide oil production will have to decrease. Obviously, if supplies decrease at a time of increasing demand, results will be truly disastrous - huge price increases and shortages. A mere thought of such a scenario unfolding can lead to panic, mass speculation, hoarding and price increases - precisely the experience of 2003 - 2008.

Had the demand for oil continued to increase exponentially as it had 2001 - 2004 and as "peak oil" model forecasters continued to assume going forward, demand would have exceeded available supply just about now. Luckily, no trend (and especially no exponential trend) can persist indefinitely and demand growth began to subside in 2005, even as world economies continued to chug along full speed ahead. By 2008, world oil demand was already contracting and this year demand is expected to fall almost as much it rose at its 2004 growth peak.

Demand growth is expected to resume in 2010. This, along with inflationary expectations, has pushed the closing spot price of West Texas Intermediate to a new post bust high of $77.58 per barrel Thursday, an increase of 156% from the cycle daily closing low of $30.28, reached on December 23, 2008.

Will oil prices continue to march even higher? Anything is possible, but odds are stacked against it for at least a year or more. Inflationary fears have very little basis in reality and renewed strong oil demand growth forecasts for 2010 will need to be downsized.

Personal incomes are deflating. According to Bureau of Labor Statistics data, real weekly wages for private-sector workers have fallen 1.4% this year through September. Colorado announced this week that it will lower its minimum hourly wage by four cents on January 1 of next year. It is the first state to do so since the federal minimum wage law was created in 1938. There will be no cost-of-living increases for retirees from Social Security, either. Grocery stores have also confirmed the deflation story with their latest quarterly reports.

Worldwide oil demand growth rates simply can't get back up to a billion barrels a year range any time soon with oil's largest consumer's unemployment and underemployment rate at 16.8%, while capacity utilization for the primary and semifinished stages of goods production at "67.3%, a rate 14.7 percentage points below its long-run average."

West Texas Intermediate Spot Prices (Sorce: US Energy Information Administration)

When I last wrote about oil, I was lucky enough to precisely pick the bottom of the West Texas Intermediate. (According to DOE data, Texas light sweet crude hit its daily five year low of $30.28 the following Tuesday.) Back then, an ounce of gold would buy you 21.3 barrels of oil, over 25% more than the 25-year average of 16.8 barrels. Currently, we are at 13.5 barrels of oil per ounce, which is almost 20% less than average. Given the deflationary economic environment and newly overheated stock market, I would rather bet on oil taking a tumble than gold prices catching up. Especially because other commodity prices confirm this line of thinking.

Another spike in inflation adjusted prices of oil might well occur 5 - 10 years from now once world economies truly stabilize, but only if alternative energy sources are not ready to take up all of excess demand. In fact, despite best efforts from world governments and "green energy" industries, they may not be ready in time. But that is a play I can't make today. The play I could and did make was to sell my [OIL] ETF holding - a terribly imperfect bet on appreciating spot oil prices, I made back in December 2008.

I sold OIL at $25.79 / share, a gain of just over 13%; a far cry from the 156% gain in the underlying commodity spot price. Of course, the reason for the disparity is that OIL, like [USO], [DBO] and all other energy based ETNs, unlike the metal based ETFs, such as [GLD] and [SLV], never take physical possession of the underlying commodities - they trade futures, instead.

An opportunity lost - c'est la vie!