Are Oily Characters Behind Crude's Price Move?

Includes: DBO, OIL, USO
by: Investment U

My last column on crude oil prices certainly generated a number of "interesting" responses.

If you recall, I mentioned that crude oil's pullback from a high of more than $147 a barrel in early July was long overdue. With demand decreasing and supply increasing, oil is doing exactly what you'd expect it to do - drop.

But some readers were angry, calling my analysis off base. And admittedly, it is from time to time. (Caveat emptor.) But not in this case with crude oil prices - and certainly not for the reasons they cited.

For example, one reader was incensed that I claimed oil rose sharply in the first half of the year while demand was actually falling. Not possible, he huffed, and took my editors to task for letting such an outlandish statement get by them.

But maybe my editors weren't asleep in the wine cellar (this time). The Energy Information Agency announced on Tuesday, the day after we published the column, that "U.S. oil demand during the first half of 2008 fell an average of 800,0000 barrels per day compared with the same period a year ago, the biggest drop in 26 years."

The "Bubble Theory" On Crude Oil Prices

This further supports my "bubble theory" of crude oil prices.

The price of oil was actually soaring in the first six months of this year while demand was taking the biggest drop since 1972. How long could we have expected it to last?

  • Prices go up when demand goes down for all sorts of reasons, ranging from supply decreases to market speculation. This particular reader would benefit from fellow Investment U panelist Mark Skousen's new textbook "Economic Logic." (It's all there - and quicker than taking a remedial course in Economics 101.)
  • Other readers swore that the drop in the price of crude oil has nothing to do with market forces and everything to do with the upcoming election.
  • Several claimed that "they" were making it fall until November - and it will go right back up once the election is behind us.

No word, however, on whether "they" is the Bush administration that wants McCain to win or the Democratic Congressional majority that wants Obama to win. Or, for that matter, how our elected officials have the money to influence the $4.78 trillion commodity futures and options markets, where crude oil prices are actually determined. 

(If you have the answers to these questions, please send them along. I promise to run the best of them. And the winner will get a special award, our trophy for "Spending Far Too Much Time on the Internet.")

"Animal Spirits" Driving Crude Oil Prices Higher

As I've been saying for months, it is "animal spirits" - speculation - that drove crude oil prices higher while fundamentals deteriorated.

As long as all trading activity is transparent and prices aren't being manipulated, there's nothing wrong with this. Whether it has all been above board, we're about to find out, as both Congress and the Commodity Futures Trading Commission are investigating some suspicious trading activity.

As The Wall Street Journal reported Friday, "Data emerging on players in the commodity markets show that speculators are a larger piece of the oil market than previously known. The number of futures and options contracts held by traders counted as speculators - those who don't have a commercial need to mitigate the risks of energy prices in their business - rose to 49% of all crude-oil bets outstanding on the New York Mercantile Exchange, up from 38%."

But, under normal circumstances, speculators are a help, not a hindrance. They add liquidity to the market. And when they distort prices - as they occasionally do - it gives us opportunities to sell at inflated prices or buy at unreasonably low prices. What's not to like?

The only investors who get hurt are the ones who buy into the hype - in this case the "peak oil" story - and get trampled when prices revert to the mean, as they always do eventually.

If we don't like this, we can do the smart thing and not play with fire in the futures and options markets. 

Or we can write our congressional representatives. I expect my mailbag this week will tell us which ones…

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