An Oil Glut Looms?

Excerpt from Morgan Stanley strategist Andy Xie's most recent essay:

While the number of oil bears has increased, the majority remain bullish and believe that the 20% correction from the peak is temporary and prices will resume their climb. Which way the oil price will go in 2006 will be a key driver for investment performance next year, I believe.

The bears cite surging inventories everywhere and believe that there is an oil glut. The bulls believe that soft demand is temporary, that Chinese demand will resurge soon with its demand for strategic petroleum reserves as a bonus, and that Saudi Arabia will not be able to deliver on its promised production.

The momentum is clearly shifting in favor of the bear camp, in my view. Many investors that I encountered on this trip had already set up short positions in oil. The recent decline in oil prices reflects this sentiment shift, i.e., oil prices are less a factor of physical demand or supply balance than of sentiment among financial investors. The mounting evidence of an oil glut is working into prices by affecting investor sentiment.

I believe that the oil market is the most speculative among all financial markets this year. While crude inventories have risen much faster than consumption, i.e., there is an oil glut, crude prices are still 50% above last year’s averages despite the 20% tumble from the peak. Oil prices are declining slowly but not crashing because many long-term investors made portfolio allocations for oil futures in early 2005 and are having trouble facing up to the reality. Their reluctance to pull their funds out is slowing the correction in oil prices. This, of course, presents a good opportunity for traders to take short oil positions.

Most investors still cling to the notion that China and India will consume so much oil that prices will eventually be very high and, despite the recent setbacks, still hold massive positions in energy stocks. I believe that the energy sector will be in a lot of trouble next year. The irrationally high prices this year have triggered massive responses in producer and consumer behavior. The demand for oil in 2006 would surprise on the downside even if prices fall substantially and the global economy turns out to be robust.

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