Explaining Oil Price Fluctuations

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Chronic uncertainty about the future provides fertile ground for herd behavior and speculation. In 1999, for example, nobody really knew how internet commerce would play out or what a share of Amazon was worth. Maybe stock analyst Henry Blodget was right when he said in December 1998 that the figure was $400. (In fact, within a month, Amazon’s stock topped that; it now trades at about $70.) While the oil boom hasn’t reached the proportions of the dotcom bubble—not yet, anyway—some worrying similarities are emerging.

In May, a team of analysts at Goldman Sachs, one of the most active players in the oil markets, issued a report that said supply concerns could drive crude to $150 or even $200 a barrel during the next six to 24 months. It was a Blodget-like prediction and had a similar effect. The Goldman circular didn’t contain any new information about reserves or production schedules, yet on the day of its publication, prices shot up.

A similar fandango occurs around the monthly release of data about inventory levels at U.S. refineries. With the price of crude in the stratosphere, oil companies have been economizing on how much energy they use; consequently, their inventories of refined products are shrinking. This strategy has nothing to do with shortages of crude—Saudi Arabia and other producers stand ready to supply as much as the oil companies want at current prices—but traders have interpreted the inventory numbers as evidence that the market is getting even tighter and used them as a rationale to bid up prices. “We’ve gotten into a pretty crazy situation,” Allsopp says.

I stand by my view that ultrahigh prices will eventually lead to a significant increase in supply—some of it in the form of crude recovered from remote areas, some as a result of wider acceptance and use of alternative fuels—as well as a dramatic fall in demand. These stabilizers haven’t kicked in as quickly as they did during past oil shocks, but the supply picture is finally changing, as indicated, for example, by the growing public support for drilling in Alaska and offshore drilling in the Gulf of Mexico.

The oil rush isn’t confined to the continental shelf. CNBC recently reported that all over Los Angeles, “people are digging or restarting wells—even ones that only turn out 10 barrels a day.” In Canada, meanwhile, huge sums are being invested in plants and equipment capable of converting oil sands into crude.

High prices are also having an impact on demand. China and other developing countries are cutting back on the costly subsidies that have long kept petroleum prices artificially low. Sales of gas-guzzlers are plummeting, and automakers are rushing to increase production of hybrids and other fuel-efficient vehicles. Take General Motors: If it can somehow survive the next two years, in 2010 the company is expected to introduce the Chevy Volt, a plug-in compact car that could transform G.M.’s prospects. Despite all these developments, many oil industry forecasts, including the I.E.A.’s influential oil market report, see global demand rising inexorably.

Speculative manias, by their nature, are vulnerable to seemingly small events. What caused the Black Monday crash of October 1987 or the Nasdaq crash of April 2000? To this day, we don’t have convincing answers. In each case, a large number of investors became simultaneously nervous and started selling, setting off a frenzy that fed on itself. What will be the catalyst for a reversal in the oil market?

The July sell-off, which followed downbeat statements by Federal Reserve chairman Ben Bernanke, suggests it could be some unfavorable news about the world economy. If Europe and Japan follow the U.S. into recession or near-recession, developing countries will be deprived of the export growth that has driven their economies. At that point, even the oil bulls will be forced to admit the possibility of a global slump in demand, and the skeptics will finally have their day. Another possibility is that John McCain or Barack Obama could propose tapping the U.S. Strategic Petroleum Reserve, which contains more than 700 million barrels of crude. There is no guarantee that this strategy would bring down gas prices, but by signaling to OPEC and the speculators that the next administration is serious about bringing down oil prices, it might just tip the market’s psychology.

For the moment, I would advise investors to avoid the commodities markets, where the combination of leverage and volatility can have devastating effects. If you want to speculate on an oil bust, buy stock in a well-run airline or chemical company, both of which will benefit greatly from falling prices.

And if you want to unload the Hummer H2 idling in your driveway, drop me a line.

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