Oil over the place

There is nothing like big, round numbers to excite oil market pundits. At junctures such as $50 and $100 a barrel, breached in New York’s futures pits in September 2004 and January 2008, respectively, elaborate arguments were made in both the bearish and bullish camps as to why the price was either ridiculously frothy or just a taste of what was to come.

But it is not only the bulls who have egg on their faces at the moment – it is the analyst community as a whole – with fundamentals failing to explain how a nearly $100-a-barrel drop in prices could happen in just four months. Do supply and demand even matter any more when the futures pits have become the tail that wags the dog? Citigroup says that the past four years have seen a 460 per cent expansion in futures and options positions on the New York Mercantile Exchange against only 9 per cent growth in the physical market over the same period. For traders who had never seen an oil derrick up close, the liquidity of energy derivatives was an easy way to punt anything from dollar weakness to geopolitical uncertainty or even momentum for its own sake.

Dismissing sound fundamental analysis, however, is ill-advised for long-term investors. The bull case as crude surged – that consumers would not change their behaviour much at high prices and that producers could not squeeze out more barrels as prices soared – was valid only in the short term, lulling some poor sap to buy a contract at $147.27 on July 11. Claiming the world is now in a permanent sub-$50-a-barrel place would be equally foolish as projects are being cancelled at marginal oil fields worldwide. The International Energy Agency’s argument that current production costs will make $80 a new equilibrium is a sound estimate. As usual, prices will overshoot and make those who still believe in the law of supply and demand question their sanity.

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