Why is Oil Dropping (and what might its impact be)?

Oil has dropped under $60 this morning, to reach 6 month lows. Prices have "dropped more than 23% since hitting a record $78.40 in mid-July." At the same time, stocks have closed in on their May highs.

Why has oil dropped so precipitously over the past 2 months? AP notes that:

"The high prices in July and August
were largely fueled by concern over the possibility that Iran could
disrupt oil supply if sanctions were imposed or if the monthlong
conflict between Lebanon and Israel escalated. Fears of hurricane
damage to U.S. Gulf Coast refineries also drove the market higher this
summer but the storms so far have blown past the coast."

Here is a short list of the most common current explanations circulating in MSM:

1. More Supply coming online;
2. Reduction of global terror threat;
3. Cooling of hostilities between Israel and Lebanon
4. Seasonally weak demand, as Hurricaine season ends;
5. Iran cooling inflammatory rhetoric 

I find these some of the mainstream explanations unsatisfying. At the risk of creating a strawman (only to knock it down), let me put forth my top 5 list:

1. Fast money rotating out of commodities and into tech;
2. Cooling economy consuming less energy;
3. No major supply disruption from weather or Middle East;
4. Psychology peaked earlier in year; (see Business Week Cover Story)
5. Stretched consumer shifts behavior;
6. And lastly, the Weak Strong US Dollar (Crude is priced in greenbacks)

The biggest mis-statement on the mainstream list/energy discussion is the perplexing meme that somehow terror concerns have been alleviated. I find that rather astonishing, given that the leaders of two of the larger Oil suppliers  were in NY at the UN last week talking trash about the Unied States of America.

The eventual confrontation with Iran — last I checked, they had not given
up their nuclear ambitions — is still looming on the horizon.

On top of that bit of psycho-drama, we learned this weekend that US Spy Agencies Say Iraq War Worsens Terrorism Threat.

So the new idea that somehow the terror threat or the Middle East turmoil has improved fails to resonate with me.

All these explanations remian squishy, however. When in doubt, we go to the charts:

Crude Oil, 6 Month Chart
click for larger chart


Crude Oil, 3 Year Chart
click for larger chart



Major Support for Crude is at $58, minor support is at $55 and $49.

Oil is in the midst of a major correction, and by the traditional measure of 20%, can be defined as in a Bear market. The mainstream explanations are greatly over-simplified.

Why is this important? Understanding why energy prices have dropped can help you avoid positioning your portfolio on unrealistic assumptiuons . . .


Oil Falls Below $60 a Barrel As Supply Concerns Ease
Associated Press, September 25, 2006 4:36 a.m.

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What's been said:

Discussions found on the web:
  1. mh497 commented on Sep 25

    Boone Pickens was quoted last week going with #2, a cooling economy is slowing demand.

  2. lurker commented on Sep 25

    Hi Barry. I would be curious how you would analyze the charts of gold and the gold stocks as well. Only if that interests you, of course. ciao.

  3. MrMarket commented on Sep 25

    Oil…is correcting itself relative to GC. ☺

  4. J Arp commented on Sep 25

    I couldn’t agree more with you regarding the reasoning behind the fall in oil prices. A look at the CRB shows oil is not alone. Copper, rubber, precious metals have all fallen. This reflects the slowing of money velocity. The global economy is slowing. EIA publishes imports, production and stocks of oil. If you add the first two, subtract changes in the last you get U.S. consumption. Consumption has fallen off greatly, showing an economy falling into recession. That’s the fundamental story. Add speculative position squaring and we get the free fall. The equity market is reading this all wrong. The falling commodities prices are a symptom of the problem, not the stimulus of a rebound.

    It will take continued bad econ prints for the equity market to get the joke.


  5. Mike commented on Sep 25

    I would add that I think that the fast money is getting stopped out (and smoked) and scrambling to sell. I don’t think Amaranth was the only fund with a bet gone bad, most especially considering that it is a 23% correction in a very short time.

  6. Royce commented on Sep 25

    I’m going with fast money bailing out on their speculations. The falling demand aspect would show up in energy department or other industry statistics, wouldn’t it?

  7. Ddrich commented on Sep 25

    Your strawman #1 gets my vote. War speculation that drove oil into “contango” required hedging forward to $70-78/bbl to keep from taking a loss. July hit that target.

    Contango is not over, but on the wain as hype (futures) catches up with reality (spot).

  8. Steve commented on Sep 25

    I think russwinter hit the nail on the head:

    Goldman Sachs Games Gasoline Futures
    Goldman Sachs elected in July to arbitrarily game their widely followed commodity index. Illustrating how this can be done, and with no questions asked, they suddenly changed the unleaded gasoline component of the index from 8.45% to 2.30%, right at a point in time when speculative funds were heavily long. In addition GS blew up the arbs with this jewel,

    “On July 12, 2006 Goldman, Sachs & Co. announced that, for the roll occurring in September 2006 (the September Roll) in relation to the Goldman Sachs Commodity Index (GSCI) futures contract expiring in October 2006, it would roll the existing portion of the GSCI that is attributable to the Reformulated Gasoline Blendstock for Oxygen Blending (RB) futures contract on the New York Mercantile Exchange but would not roll any portion of the GSCI that is attributable to the New York Harbor Unleaded Gasoline contract (HU) contract into the RB contract.”

    What a coincidence, duh. Per usual I smell another rat. The result was predictable enough given that index-linked commodity funds would be forced to liquidate 73% of their unleaded gasoline futures to hit the absurd tiny new 2.30% threshold. And not surprisingly, this energy liquidation has been so intense that specs are now modestly short both unleaded and heating oil, and are completely gone from long positions in crude oil. This price rout has absolutely nothing to do with demand fall offs. In actuality, the post Labor Day seasonal gasoline consumption drop has been slow in developing, with the last four week average year over year, up a substantial 5.4%.

    In addition this plunge has been a key driver in the drop in all kinds of Old Maid Card and Ponzi finance related interest rates, under the “inflation is being licked” banner. There has even been a nice pickup in refi and housing purchase activity, suggesting to me that September housing data will come in better, sparking more soft landing talk there. As they jettison energy positions, speculators have instead continued to intensely pile into 10 year Treasury notes with abandon, and are now net long a stunning 401,314 contracts. Yields have fallen so low (4.59% on the ten year and a whopping 66 bp below the Fed fund rate), that at last, it may have gotten the attention of FCBs, who liquidated a historically high $16.1 billion in Treasuries in the latest reporting week. My hunch is that the FCBs trump offside Riskloves and speculators any time, and any place, making this weekend’s set up dicey at best for the bulls.

  9. snook commented on Sep 25

    Lets see if crude closes here today < $60 / bbl. If so, we could see some capitulation in the energy markets this week. Although the trrend in energy prices should still be up long term based on economic growth, I yeild to the efforts of the US Fed to stop inflation and the efforth being spoken about by China. If China can effect a moderation in their growth is the big question. If housing in the US gets slammed year end, could be a phsycological thorn in the US's economic side. However, some of these premiums coming out of oil priceing has been talked about since the begining of the year. volitility should persist as seasonal and secular trends continue in that market....good time to be a little short! Don't expect OPEC to help out.

  10. KD commented on Sep 25

    The easy flip from $80 & Mid East worries in July to sub $60 and excess supply tells us a lot about the speculative long. You can bet that not too many smart people were shorting above $70. Shorts getting active now.

  11. M1EK commented on Sep 25

    I’m voting for #3. Oil traders were quaking every time a tropical wave came into the gulf this year. When nothing happened, goodbye storm premium. (Note that the drop has coincided quite nicely with this year’s hurricane season).

  12. Aaron commented on Sep 25

    Ummm, mid-terms?

  13. BDG123 commented on Sep 25

    Wall Street is so funny. When oil was rocketing any particular statement or nit was a catalyst for higher prices. Or so we were told. Now that prices start dropping, Chavez comes out and calls Bush the devil and oil goes down. How many times did world events happen when oil was less than $20 and nary a time did it drive prices to $80. I can’t tell how much is misinformation and how much is simply people who don’t know what they are talking about moving their lips.

  14. j d ess commented on Sep 25

    Oil traders were quaking every time a tropical wave came into the gulf this year.

    salivating’s more like it. but i agree the hurricane premium can be dismissed easily. fast money may be rotating out of oil, but a big reason it rushed in was the assumption of another harsh hurricane season. not that the season hasn’t been active (12 named storms), just that few of the storms have hit the areas traders hoped…er, feared.

    also of note regarding the lack of damage on these shores is there won’t be a construction pop — though granted a ton of rebuilding from last year is still happening. it’s often said though these storms are economically net positive given all the insurance payouts.

  15. j d ess commented on Sep 25

    er, that should read “the hurrican premium *cannot* be dismissed easily…”

  16. ddresser commented on Sep 25

    Reasons 1 – 4 are sound. But a falling dollar? Shouldn’t that make oil prices rise in dollar terms, as oil priced in dollars becomes more attractively priced in Euros and Yen?

  17. tjofpa commented on Sep 25

    Hey Lurker, let me analyze the Gold Stocks for u;

    They’ve been a HOUSE OF PAIN all Qtr long. Now fund managers have two days to decide if they keep them on their Qtr End statements. Get the picture.

    We got downgrades on the Steels and Aluminums today and I wouldn’t be surprised to see downgrades on the Golds tomorrow or Wed.

    Shenanigans – Come on along and play Shenanigans

    I’m betting that the lid comes off later this week.

  18. BDG123 commented on Sep 25

    I think he mistyped. The dollar has been relatively strong recently. And oil is inversely correlated to the buck.

  19. Barry Ritholtz commented on Sep 25

    The dollar index is down significantly from its Q3 peaks; It is also down significantly for the year.

    It is up however, from its recent lows

    I usually prefer weekly to daily charts (less noise) but even the daily shows the index US dollar index moving towards the bottom of its range

  20. dl commented on Sep 25

    commodities trade inversely to the $

  21. tjofpa commented on Sep 25

    … and will we see another “lagged effect” in the $ index as it reacts to today’s increase in expectations for a rate cut by year-end => tomorrow.

  22. NotAPro commented on Sep 25

    There was a Congressional report released a couple of months ago that indicated that a large part of the high price of oil was due to speculation, specifically the over the counter (not sure if this the correct term), largely unregulated trade.

    If there is less speculation, presumably the price drops.

  23. lurker commented on Sep 25

    thanks tjopa. your perspective is interesting and sounds sound. good as you know what.
    House of Pain—LOL.

  24. babycondor commented on Sep 25

    “Understanding why energy prices have dropped can help you avoid positioning your portfolio on unrealistic assumptiuons . . .”

    Could someone help me out here and clarify what are REALISTIC assumptions vis-a-vis energy, and how those assumptions would be reflected in my portfolio’s positions?

  25. MDDwave commented on Sep 25

    One cynical view may include the reason for lower oil prices is that the big four major oil companies have essentially become a monopoly. By manipulating the oil to lower prices temporarily, it is a common tactic to eliminate competition from creeping in.

  26. Robert Cote commented on Sep 25

    20 plus posts and no one mentions the possibility that the run past $58 was irrational? I think the emotional reasons why energy rose are the interesting events not the return to rationality. Energy just wasn’t ever so rare or necessary as to support $80 oil, we all seem to know that now. Geologic extracted chemical energy prices are increasingly capped by alternatives; a breakthrough in either superconduction or PV conversion efficiency would turn oil into a natural resource like bauxite or forest products. Conversely, the equally remote possibility of definitive peak oil would suggest a rush to control the remaining supplies. I guess my point is that there are too many competing ideas to make rational predictions. That’s not a formula for making investment decisions.

  27. Bob_in_ma commented on Sep 25

    I’ve heard that after the big jumps in prices over the last couple years, big consumers of oil have been building storage and keeping greater inventory on hand. Sooner or later, they’ll decide they have enough. Probably sooner with the price falling.

    Wasn’t the U.S. strategic reserve supposed to reach capacity around now too?

  28. KP commented on Sep 25

    What’s rational about anything in the market over the last 10 years? Dot-com specualtion, current real estate specualtion, commodity speculation, oil speculation. The list goes on and on. NO ONE wants to be long(I mean truely long) anymore.

  29. Brian commented on Sep 25

    Ok. How long is this short energy/buy tech thing going to keep working?

  30. V L commented on Sep 25

    “And lastly, the Weak US Dollar (Crude is priced in greenbacks)”

    I could be missing something but I see oil as more expensive (for America) when the dollar is weakening; thus, the price should go up (not down) because of the falling dollar (assuming demand and supply are constant).
    Weakening dollar is analogous to the rest of the world getting a discount (at the expense of USA) when buying oil.

  31. V L commented on Sep 25

    In other words, falling dollar makes oil cheaper in other currencies but more expensive in US dollars.

  32. RW commented on Sep 25

    It’s worth observing I think that the substitution rule does not apply in the short- to intermediate-term in cases where extremely high infrastructure requirements exist; e.g., it was obvious that switching to anything like a 70/30 ethanol-gasoline mix in the US wasn’t going to happen, not simply because producing biomass in temperate climates for conversion to combustion involves a negative energy budget (it costs more btu’s to produce and refine than it provides in output) but because ethanol requires an alternative refining, storage and transportation infrastructure (you can’t even use the same pipe as oil) so billions of dollars and a decade or more of construction would be required to provide it as substitution option (modified engines are involved too of course).

    The only alternative to petroleum products generally and gasoline in particular at this point in time is to use less of it if you can and perhaps hope the price remains high enough, long enough to encourage investment in alternatives that, with the exception of oil (petro-lobby) and ethanol (agri-lobby), are typically not publicly subsidized.

    Don’t think the observation that oil companies may be squeezing out competition is implausible but regardless all of BR’s reasons seem plausible to me as does the observation that end Q3 is typically the time when winter-mix gasoline is produced, saving the refineries the trouble and cost of producing mixes that must vary according to the requirements of individual states. Frankly I wouldn’t even rule out some political play here: last I heard over 80% of oil industry donations went to Republicans so why not indirectly ‘donate’ more via a supply chain tweak, eh?

    Have to agree there are too many variables and cross-currents to make a rational intermediate-term investing decision at this point, at least for small investors such as moi, but even though I’m not overweight oil I’m not tossing it out either; companies that can make a profit at $25/bbl will do just fine at $50/bbl in the long run and, for the rest, hell I’ll just raise some more cash.

  33. Estragon commented on Sep 25

    The Saudi’s are just pointing out that corn is for Corn Flakes, by burning the fingers of investors who thought corn was for Hummers.

  34. david foster commented on Sep 25

    Substitution is impractical in the near term if it means reenginering vehicles (like cars that run on 85% ethanol or on hydrogen), however, a form of substitution can take place in choice of transportation modes. If UPS shifts more of its long-haul ground freight from truck to rail, for example, that reduces total fuel consumption. There are also air freight vs ocean freight tradeoffs that can be made in the international arena.

  35. Age Of Tyranny News commented on Sep 25

    Why is Oil Dropping (and what might its impact be)?

    BigPicture reports in Why is Oil Dropping (and what might its impact be)? that Oil has dropped under $60 this morning, to reach 6 month lows. Pric …

  36. Tim commented on Sep 25

    I don’t care why oil prices are dropping.

    All I know is a major long term uptrend was recently broken and I’m looking to trade in the direction of the new trend (most likely down).

  37. tjofpa commented on Sep 29

    “December copper closed at $3.4605 a pound, up 3.25 cents for the day and fractionally higher for the week and month. ”

    So much for Mish and Dr Copper….
    and this while Gold and Silver both fell in Sept.

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