Oil bubble burst

Excuse my giving myself a pat on the back but, as readers of this blog would know, I did say that oil prices would head towards $100. I said this at a time when oil was ruling at $140 and people thought it was headed towards $200. I based my forecast on two facts: the run-up in oil prices had been too steep; and the supply-demand imbalance was too small to warrant an increase of the order we had seen.

I did not say so at the time but we must also recognise that the world's sole superpower will not accept a situation where oil prices threaten to destabilise the US economy as well as the world economy. And it has some ability to influence oil prices. President Bush's visit to Saudi Arabia and some tough talk on his part elicited an assurance from the Saudis about an increase in output. Demand has been moderated by the passing on of some of the increase in oil prices to users. The SEC has toughened norms for speculators in oil. All this has combined to force down oil prices.

I read an excellent analysis in ET today of the issues related to the oil bubble. The author, a Chief economist with a US think-tank, addresses each one of the arguments made as to why the oil price rise was related to fundamentals and not speculation. He shows the arguments are dead wrong ( quotes from the article in italics:

• Oil prices rose because of a weak dollar: The price of oil has risen far more than the dollar has fallen. That means that oil prices have increased in other countries, which should have reduced, not increased, demand.
• Oil producers have held back production in anticiption of higher oil prices down the road: Nor have there been any report of unusual production cutbacks — the linchpin of the second argument. Indeed, the spike in oil prices actually gives independent producers an incentive to boost production.
• There can't be speculation in oil because inventories have not risen: the storage argument fails to recognise different types of inventory. Thus, record-high speculative prices have likely caused bunker traders to release inventory, but those releases may have been purchased by speculators who are now active lessees of commercial storage capacity. The implication is that speculators can drive up prices and increase their inventory holdings even as total commercial inventories remain little changed.
  

<>The author also underlines the fundamental change in the character of oil trading in recent years: speculative trades account for 70% of all trades compared to 37% seven years ago.
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