Unwinding but Not Relaxing

30 August 2004



Oil Drops on Profit-Taking

Markets are the most efficient device the human race has created for the allocation of scarce resources, or more accurately, the least inefficient. They do so by the pricing mechanism, which according to theory, changes as new information reaches participants. Like most theory, it is accurate in broad terms and dead wrong when faced with short timeframes and irrational behavior by participants. So, the recent drop in oil prices is no reason to uncork the champagne just yet.

After making a serious charge at $50 a barrel in mid-August, light crude in New York finished the week closer to $40 a barrel. In London, Brent crude (a less valuable variety of oil) broke $40 with a weekly low of $39.80. Based on prices alone, it would be tempting to declare the oil price problem a thing of the past. That is why prices must be analyzed in context.

Hotheads sabotaged no fewer than eight pipelines in Iraq on Thursday of last week. Yukos, the Russian oil company, seized records on the same day amid reasonable rumors that its unpaid tax bill of $3.4 billion might approach $10 billion. The northern hemisphere winter will arrive in a few months, driving up demand for heating oil. And China's economy shows signs of overheating rather than slowing down. The truce in Najaf may help Iraq's political situation, but oil was falling before Ayatollah Sistani returned from London to force a temporary (and it will be temporary) cessation of fighting.

All of these are reasons for the price of oil to rise, not fall, so why did the price come down? Simply put, there were a lot of speculators in the market who had bought up oil futures, and they decided that they had made all that they were going to make on the current increase. They began to sell to take their profits, and that flood of oil brought the price down. Speculators serve a useful purpose in a market by providing additional liquidity, but the price for that is markets that over-shoot their rational price targets. Speculators drive prices too high and too low; they exaggerate market swings more often than not.

When the oil speculators have booked their profits, the prices will again start to rise. When they are finished unwinding their positions, supply will decrease (and OPEC is already pumping near capacity, so there is no way to take up the slack). Moreover, all of the market conditions that drove the price up in the first place remain. A great many of these speculators will get back into the game on the long side; they'll be buying oil again very soon. They have another five weeks before the quarter ends, and that's plenty of time to turn another trade.


© Copyright 2004 by The Kensington Review, J. Myhre, Editor. No part of this publication may be reproduced without written consent.


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