The Oil Bubble Burst by Speculators Retreat

More than a year ago the commodities markets started acting peculiar as speculators, not supply and demand, drove the price of crude oil to its real street value. For those unfamiliar with how the commodities markets work it’s (to put it simply) a bet on a future price. It’s intended to work so that XYZ Company can state what they will pay for a commodity such as oil when it becomes available. The problem we have recently experienced is when the options and futures to buy are snatched up by “middle men” not in the business of selling or refining oil. If there are enough of them buying and selling “paper oil” the price will skyrocket before even one drop is transferred.

One might ask, where did these oil bandits come from? The answer is fairly simple; add deregulation of the commodities market to a free falling stock market and tumbling USA real estate and you create a feeding frenzy for large funds and brokerage firms to speculate with the funds previously used in stocks and the property market and drive the price up.

In the span of one year, the consumption of oil stayed at the same rate it had in prior years. It was only increasing in price not demand. It was not until the US congress decided it might be a good idea to investigate these unfounded price spikes that the price began to free all last July.

The culprits: California Pension Fund, Harvard Endowment, along with hedge funds and sovereign wealth funds to name a few. It’s groups like these who have no intention or means to take delivery of the oil yet they were buying and selling the total supply many times over. In five years the amount of money these groups were investing in these markets went from 13 billion to over US $300 billion. That should give you an idea as to what kind of impact they had.

Many people like to blame the rise in the price of oil on Bush and Iraq but the fact is, they had little or no real influence on the price what so ever. Last year for ever barrel of oil actually used in America, twenty seven barrels were bought and sold on the Mercantile Exchange.

When asked by the US Congress last summer, Lawrence Eagles of JP Morgan said supply and demand is the primary factors that determine price. The very same day in an email to clients the Chief Investment Officer of JP Morgan said the opposite of that stating “an enormous amount of speculation” and “ US $140 in July 2008 was ridiculous”. A few days later the price of oil jumped 25 dollars in a single day to US $149. No increase in demand or drop in supply could be blamed for this. Even the US Department of Energy stats that according to demand and then current production the price should have been dropping not rising.

If you want to point fingers you can look to the investment banks like JP Morgan, Morgan Stanley, Barclays and Goldman Sachs but at the end of the day they do what their clients want and that is us. For the last 15 years we have as a global economy experienced astonishing growth and now we demand and expect the same from our investments. We’ve seen the bubble move from high tech to real estate to commodities. All are great investments but one needs to maintain realistic goals.

It’s likely the negative consequences of this recent fiasco will be felt for many years. The flip side is in great economic turmoil the greatest opportunities are found and empires forged. You are fortunate to live in a time where you can choose the path of leader or follower.