Crude Oil Prices

Crude Oil Prices: Are “Oily Characters” Behind the Move?

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, August 18, 2008: Issue #840

My last column on crude oil prices certainly generated a number of “interesting” responses.

If you recall, I mentioned that crude oil’s pullback from a high of more than $147 a barrel in early July was long overdue. With demand decreasing and supply increasing, oil is doing exactly what you’d expect it to do - drop.

But some readers were angry, calling my analysis off base. And admittedly, it is from time to time. (Caveat emptor.) But not in this case with crude oil prices - and certainly not for the reasons they cited.

For example, one reader was incensed that I claimed oil rose sharply in the first half of the year while demand was actually falling. Not possible, he huffed, and took my editors to task for letting such an outlandish statement get by them.

But maybe my editors weren’t asleep in the wine cellar (this time). The Energy Information Agency announced on Tuesday, the day after we published the column, that “U.S. oil demand during the first half of 2008 fell an average of 800,0000 barrels per day compared with the same period a year ago, the biggest drop in 26 years.”

The ”Bubble Theory” On Crude Oil Prices

This further supports my “bubble theory” of crude oil prices. The price of oil was actually soaring in the first six months of this year while demand was taking the biggest drop since 1972. How long could we have expected it to last?

Prices go up when demand goes down for all sorts of reasons, ranging from supply decreases to market speculation. This particular reader would benefit from fellow Investment U panelist Mark Skousen’s new textbook “Economic Logic.” (It’s all there - and quicker than taking a remedial course in Economics 101.)

Other readers swore that the drop in the price of crude oil has nothing to do with market forces and everything to do with the upcoming election.

Several claimed that “they” were making it fall until November - and it will go right back up once the election is behind us.

No word, however, on whether “they” is the Bush administration that wants McCain to win or the Democratic Congressional majority that want Obama to win. Or, for that matter, how our elected officials have the money to influence the $4.78 trillion commodity futures and options markets, where crude oil prices are actually determined.

(If you have the answers to these questions, please send them along. I promise to run the best of them. And the winner will get a special award, our trophy for “Spending Far Too Much Time on the Internet.”)

“Animal Spirits” Driving Crude Oil Prices Higher

As I’ve been saying for months, it is “animal spirits” - speculation - that drove crude oil prices higher while fundamentals deteriorated.

As long as all trading activity is transparent and prices aren’t being manipulated, there’s nothing wrong with this. Whether it has all been above board, we’re about to find out, as both Congress and the Commodity Futures Trading Commission are investigating some suspicious trading activity.

As The Wall Street Journal reported Friday, “Data emerging on players in the commodity markets show that speculators are a larger piece of the oil market than previously known. The number of futures and options contracts held by traders counted as speculators - those who don’t have a commercial need to mitigate the risks of energy prices in their business - rose to 49% of all crude-oil bets outstanding on the New York Mercantile Exchange, up from 38%.”

But, under normal circumstances, speculators are a help, not a hindrance. They add liquidity to the market. And when they distort prices - as they occasionally do - it gives us opportunities to sell at inflated prices or buy at unreasonably low prices. What’s not to like?

The only investors who get hurt are the ones who buy into the hype - in this case the “peak oil” story - and get trampled when prices revert to the mean, as they always do eventually.

If we don’t like this, we can do the smart thing and not play with fire in the futures and options markets.

Or we can write our congressional representatives. I expect my mailbag this week will tell us which ones…

Good Investing,

Alex

Today’s Investment U Crib Sheet

Investing without a plan in oil, or any market, is little more than gambling. A simple game using a bag of marbles can teach us a powerful lesson on speculation… To start the marble game, participants are each given $100,000 in play money to seed their portfolio. They are also given a bag with 20 marbles, each one representing either a losing (black marble) or a winning (white marble) trade. There’s one more interesting variable. Sixty percent of the marbles in the bag are winners while 40% are losers. And each marble is replaced after it is drawn. One of the winners is a “10 times winner,” and one of the losers is a “5 times loser.”
By reaching into the bag and randomly pulling out a marble, the participant learns what impact it has on their portfolio.

Now, the odds of winning in this marble game are far higher than the odds we face in the market. Still, when conducted with Investment U seminar audiences, more than two-thirds of the participants always lose money. And a full one-third goes bankrupt.

How is that possible? How can a majority of people lose in a game in which the odds are so heavily in their favor? The answer is very simple: Those who lose money do so because they have no idea how much they should be investing in any one marble draw. They are playing the game without a “system,” so they’re really doing nothing but gambling. This sort of approach doesn’t win the marble game.And, in the real-world investment game, it won’t lead to long-term wealth.
Stop “losing your marbles” and learn that the key to success - and the strategy you should use in your portfolio - is position sizing.