Back in January, when the price of crude was just below $100 a barrel, I predicted a crash in the oil market. That would be the same oil market that has since superspiked its way toward $150 before falling nearly $20 over the course of a few days in July. Some readers have demanded a retraction; others have offered to sell me their S.U.V.'s. However, I am sticking with my prediction: Within two or three years, the price of oil will drop to below $50 a barrel. Indeed, I'm more bearish than ever.

Here's why: The oil market has become unhinged from the basic laws of supply and demand. There are two theories as to why this is the case. The first, a favorite of Arab oil sheiks, dissident financiers, and members of Congress, holds that market manipulators are to blame. During House and Senate hearings held over the summer, George Soros and others described the recent influx into the oil markets of hedge funds, mutual funds, Wall Street banks, and other financial operators as an insidious development. Michael Masters, founder of investment firm Masters Capital Management, said that if regulators limited speculation, the price of crude would drop by $65 to $70 a barrel.

The effort to scapegoat speculators was of a piece with this summer's attempts to blame short-sellers for the problems facing U.S. banks: In both cases, regulators, Congress, and consumers were looking for someone, anyone, to blame for a market that seemed to have turned ugly.

Countering this view are government officials and oil industry executives, who say that prices are simply responding to economic fundamentals. (The fact that high prices add mightily to oil industry coffers is simply a happy coincidence.) With reserves shrinking and consumption growing strongly, particularly in China and India, they say the market is telling us that we need to economize on oil use and discover some new supplies. The International Energy Agency, a Paris-based body that represents the interests of major oil-importing countries, calls blaming speculation "an easy solution" that allows people to ignore the need to locate new oil supplies and increase energy efficiency.

One explanation presents the oil market as a conspiracy; the other portrays it as an omniscient and calculating machine. Both are incomplete. A more revealing way to look at it is as a game of poker played by producers, consumers, and investors. No one can see the cards, so there is a lot of bluffing and intimidation. There comes a time-and we could well be there now-when no one believes anyone else. The outlook for supply and demand at the moment is particularly opaque; many oil traders don't know what to think, which is the main reason prices are so jittery. Congress is equally adrift, which makes it jumpy, especially when constituents are calling to complain that it now costs more than $100 to fill up the Escalade. Only after prospects become clearer will the markets calm down.

Much of the action in oil trading plays out in the futures markets, an often misunderstood place where contracts for delivery of crude are bought and sold. Arbitrage ensures that future prices and spot prices-what's paid for oil delivered today-generally move together. If investors pushed up the price of crude for delivery in six months' time and the spot price stayed put, entrepreneurs could buy on the spot market, put the oil into storage, and deliver it in six months at the higher future price. Everybody in the market knows this, so when future prices rise, spot prices do too. There doesn't have to be any actual hoarding of crude; the threat alone is enough to make the prices move together.
There is no doubt that financial investors play an increasingly large role in the market. At the New York Mercantile Exchange, one of the world's biggest oil bourses, financial players account for up to 70 percent of trading; oil producers and companies account for most of the rest, mainly in the form of spot demands for crude that are part of the regular course of doing business.

Some investors are in for the long haul. Pension funds, university endowments, sovereign wealth funds, and other index investors buy and hold baskets of commodities futures, treating them much the same as any other investment. Before the contracts expire, these investors roll them over and, they hope, earn a profit. As long as prices keep going up, this is a moneymaking strategy.

Then there are the old-fashioned speculators-hedge funds, rich investors, and Wall Street banks-who invest based on their view of how prices will move. These investors tend to be in and out of the market fast, reacting to news and hoping to predict where prices will go. It is this latter group of quick-hit investors who dominate the market. According to a June research report from Goldman Sachs, speculators account for about 42 percent of all oil trading on Nymex; index investors, 11 percent; and oil producers and other companies make up the rest.

By some estimates, commodity index funds now have upwards of $250 billion in assets, compared with just $13 billion at the end of 2003. Nobody knows how much hedge funds and the proprietary trading desks of big banks have been betting on crude, but it is safe to assume that the figure is large. During the past year, so-called macro funds, which place bets on currencies and commodities, have been the best-performing types of funds, while on Wall Street, commodities trading has provided a substantial and much needed source of profit.

Soros and the other finger pointers are surely correct when they say that the weight of investment capital has contributed to the runup in the price of crude. But to assert that blind speculation alone is responsible for current prices is to misunderstand how the market works-and oversimplify trading that is unusually complex, influenced by global politics and economics. Expectations are what drive the futures market, particularly expectations about the long-term cost of crude. If prices rise much above that level, speculators will eventually bet against them, bringing them back down.

Black Hole (cont.)

This year, however, the equilibrating mechanism has stopped working because, until recently, almost nobody was willing to bet that oil prices would drop. Paradoxically, it was the absence of speculators (bearish ones) that kept prices up. "What has happened is that the market's anchor has disappeared," says Christopher Allsopp, the director at the Oxford Institute for Energy Studies and a former member of the Bank of England's monetary-policy committee. "The market doesn't really know what the medium-term fundamentals are anymore."

One reason for the confusion is the ongoing debate over whether global oil production is topping out, as a number of engineers and academics in the so-called peak-oil movement have claimed. I'm not convinced. While some big non-OPEC fields are declining faster than expected-particularly in Mexico, the North Sea, and Russia-production in Brazil, Canada, the Caspian region, and elsewhere in Asia is increasing, and some big OPEC producers, like Saudi Arabia, are expanding their capacity. Despite the ongoing production problems in Iraq, Nigeria, and Venezuela, most experts predict that crude stockpiles will rise considerably during the next couple of years.

Beyond that, who knows? Pessimists point to reports that the International Energy Agency, which has been carrying out a new survey of global production capacity, is expected to predict a crunch through 2030, as increases in crude supply fail to match rising demand in the developing world.

But many major producers, including Iran, China, and Venezuela, refused to cooperate with the agency's researchers, and the situation in Saudi Arabia, the world's biggest producer, remains extremely murky. In the '90s, the Saudis, with a bit of prodding from the U.S., could be relied on to prevent big spikes in oil prices by flooding the market if necessary. Today, the Saudis and their Gulf allies appear unwilling or unable to open the spigots. Some analysts interpret this reluctance as evidence that the vast Middle Eastern fields will soon be tapped out. My view is that the House of Saud's wish for stability in the oil markets has taken second place to its immediate need for money to pacify its restive and rapidly growing population. (One delicious, though unproven, conspiracy theory I came across recently: In order to keep the price of crude high, the Saudis have been quietly feeding misinformation about their giant fields to the peak-oil crowd.)
Chronic uncertainty about the future provides fertile ground for herd behavior and speculation. In 1999, for example, nobody really knew how internet commerce would play out or what a share of Amazon was worth. Maybe stock analyst Henry Blodget was right when he said in December 1998 that the figure was $400. (In fact, within a month, Amazon's stock topped that; it now trades at about $70.) While the oil boom hasn't reached the proportions of the dotcom bubble-not yet, anyway-some worrying similarities are emerging.

In May, a team of analysts at Goldman Sachs, one of the most active players in the oil markets, issued a report that said supply concerns could drive crude to $150 or even $200 a barrel during the next six to 24 months. It was a Blodget-like prediction and had a similar effect. The Goldman circular didn't contain any new information about reserves or production schedules, yet on the day of its publication, prices shot up.

A similar fandango occurs around the monthly release of data about inventory levels at U.S. refineries. With the price of crude in the stratosphere, oil companies have been economizing on how much energy they use; consequently, their inventories of refined products are shrinking. This strategy has nothing to do with shortages of crude-Saudi Arabia and other producers stand ready to supply as much as the oil companies want at current prices-but traders have interpreted the inventory numbers as evidence that the market is getting even tighter and used them as a rationale to bid up prices. "We've gotten into a pretty crazy situation," Allsopp says.

I stand by my view that ultrahigh prices will eventually lead to a significant increase in supply-some of it in the form of crude recovered from remote areas, some as a result of wider acceptance and use of alternative fuels-as well as a dramatic fall in demand. These stabilizers haven't kicked in as quickly as they did during past oil shocks, but the supply picture is finally changing, as indicated, for example, by the growing public support for drilling in Alaska and offshore drilling in the Gulf of Mexico.

The oil rush isn't confined to the continental shelf. CNBC recently reported that all over Los Angeles, "people are digging or restarting wells-even ones that only turn out 10 barrels a day." In Canada, meanwhile, huge sums are being invested in plants and equipment capable of converting oil sands into crude.

High prices are also having an impact on demand. China and other developing countries are cutting back on the costly subsidies that have long kept petroleum prices artificially low. Sales of gas-guzzlers are plummeting, and automakers are rushing to increase production of hybrids and other fuel-efficient vehicles. Take General Motors: If it can somehow survive the next two years, in 2010 the company is expected to introduce the Chevy Volt, a plug-in compact car that could transform G.M.'s prospects. Despite all these developments, many oil industry forecasts, including the I.E.A.'s influential oil market report, see global demand rising inexorably.

Speculative manias, by their nature, are vulnerable to seemingly small events. What caused the Black Monday crash of October 1987 or the Nasdaq crash of April 2000? To this day, we don't have convincing answers. In each case, a large number of investors became simultaneously nervous and started selling, setting off a frenzy that fed on itself. What will be the catalyst for a reversal in the oil market?

The July sell-off, which followed downbeat statements by Federal Reserve chairman Ben Bernanke, suggests it could be some unfavorable news about the world economy. If Europe and Japan follow the U.S. into recession or near-recession, developing countries will be deprived of the export growth that has driven their economies. At that point, even the oil bulls will be forced to admit the possibility of a global slump in demand, and the skeptics will finally have their day. Another possibility is that John McCain or Barack Obama could propose tapping the U.S. Strategic Petroleum Reserve, which contains more than 700 million barrels of crude. There is no guarantee that this strategy would bring down gas prices, but by signaling to OPEC and the speculators that the next administration is serious about bringing down oil prices, it might just tip the market's psychology.

For the moment, I would advise investors to avoid the commodities markets, where the combination of leverage and volatility can have devastating effects. If you want to speculate on an oil bust, buy stock in a well-run airline or chemical company, both of which will benefit greatly from falling prices.

And if you want to unload the Hummer H2 idling in your driveway, drop me a line.

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