Explaining Oil Price Fluctuations

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Back in January, when the price of crude was just below $100 a barrel, I predicted a crash in the oil market. That would be the same oil market that has since superspiked its way toward $150 before falling nearly $20 over the course of a few days in July. Some readers have demanded a retraction; others have offered to sell me their S.U.V.’s. However, I am sticking with my prediction: Within two or three years, the price of oil will drop to below $50 a barrel. Indeed, I’m more bearish than ever.

Here’s why: The oil market has become unhinged from the basic laws of supply and demand. There are two theories as to why this is the case. The first, a favorite of Arab oil sheiks, dissident financiers, and members of Congress, holds that market manipulators are to blame. During House and Senate hearings held over the summer, George Soros and others described the recent influx into the oil markets of hedge funds, mutual funds, Wall Street banks, and other financial operators as an insidious development. Michael Masters, founder of investment firm Masters Capital Management, said that if regulators limited speculation, the price of crude would drop by $65 to $70 a barrel.

The effort to scapegoat speculators was of a piece with this summer’s attempts to blame short-sellers for the problems facing U.S. banks: In both cases, regulators, Congress, and consumers were looking for someone, anyone, to blame for a market that seemed to have turned ugly.

Countering this view are government officials and oil industry executives, who say that prices are simply responding to economic fundamentals. (The fact that high prices add mightily to oil industry coffers is simply a happy coincidence.) With reserves shrinking and consumption growing strongly, particularly in China and India, they say the market is telling us that we need to economize on oil use and discover some new supplies. The International Energy Agency, a Paris-based body that represents the interests of major oil-importing countries, calls blaming speculation “an easy solution” that allows people to ignore the need to locate new oil supplies and increase energy efficiency.

One explanation presents the oil market as a conspiracy; the other portrays it as an omniscient and calculating machine. Both are incomplete. A more revealing way to look at it is as a game of poker played by producers, consumers, and investors. No one can see the cards, so there is a lot of bluffing and intimidation. There comes a time—and we could well be there now—when no one believes anyone else. The outlook for supply and demand at the moment is particularly opaque; many oil traders don’t know what to think, which is the main reason prices are so jittery. Congress is equally adrift, which makes it jumpy, especially when constituents are calling to complain that it now costs more than $100 to fill up the Escalade. Only after prospects become clearer will the markets calm down.

Much of the action in oil trading plays out in the futures markets, an often misunderstood place where contracts for delivery of crude are bought and sold. Arbitrage ensures that future prices and spot prices—what’s paid for oil delivered today—generally move together. If investors pushed up the price of crude for delivery in six months’ time and the spot price stayed put, entrepreneurs could buy on the spot market, put the oil into storage, and deliver it in six months at the higher future price. Everybody in the market knows this, so when future prices rise, spot prices do too. There doesn’t have to be any actual hoarding of crude; the threat alone is enough to make the prices move together.

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