Thursday, September 14, 2006

Oil Prices/Commodities

The title of this post links to a story in the Seattle Times that quotes an energy consultant:

"All the hurricane flags are flying" in oil markets, said Philip Verleger, a noted energy consultant who was a lone voice several years ago in warning that oil prices would soar. Now, he says, they appear to be poised for a dramatic plunge.

I don't know if prices are about to plunge, but the story does make some good points. Much of the run up in oil prices to over $70 per barrel really had little to do with supply and demand and a lot to do with speculation in commodity markets. Much of this speculation was based on political factors such as unrest in Nigeria and the Middle East. Others speculated that global warming would continue to produce hurricane seasons like last year that would disrupt supplies in the Gulf of Mexico.

Oil traders bet that such worrisome developments would drive up the future price of oil. Oil is traded in contracts for future delivery, and companies that take physical delivery of oil are just a small part of total trading. Large pension and commodities funds are the big traders and they're seeking profits. They've sunk $105 billion or more into oil futures in recent years, according to Verleger. Their bets that oil prices would rise in the future bid up the price of oil.

That, in turn, led users of oil to create stockpiles as cushions against supply disruptions and even higher future prices. Now inventories of oil are approaching 1990 levels.

There isn't exactly peace in the Middle East but at least the Israeli Army has pulled back. Nigeria is still a dangerous place but the world seems to have adjusted to that reality. Hurricane season has so far been a non event. And inventories are so high there are reports of some oil companies leasing tankers for storage. In other words, the market has responded exactly as one would expect.

Oil isn't the only commodity that seems to have peaked. Gold and other metals have fallen too. The commodity indexes have seen some pretty severe corrections over the last couple of months. We tend to think it has more to go and remain underweight the commodity stocks and indexes.

The drop in commodity prices also tends to reinforce our belief that the Fed is at the top of it's rate raising cycle. The drop in oil and particularly gold should give the Fed some comfort that they haven't release the inflation genie from his bottle. With housing slowing (but apparently not crashing; see the uptick in purchase mortgage applications reported yesterday) and commodities correcting, we may be headed back to the days of moderate growth and inflation -- at least for a little while.

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