What the Hell Happened to Oil?

I usually try to stay away from commodities, because it is not exactly my forte. I've never studied the complex economics and statistics required to properly estimate how a shift in supply or demand, one way or another will lead to a specific change in price. When I was working in Oklahoma, predicting grain and energy prices was part of my job, and while my predictions for ethanol have more or less come true, I didn't expect grain prices to jump so much. Then again, neither did the department of agriculture. In short, I know my limits, but against the backdrop of what's going on in the broader market, something looks really fishy about the oil market right now.

Today, oil is trading around $68 a barrel, and it was trading around $66 yesterday. Yet, on Sept. 30, it was trading around $100 a barrel. While this summer's run up in oil prices into the $140s was certainly a bit bubbly, oil's recent crash also seems to be driven by something beyond fundamentals. Oil rose sharply in the first half of this year, primarily on the back of a weak dollar. As the dollar declined, investors dove into commodities in search of a hedge. However, as the dollar began to strengthen this summer, oil dropped precipitously. Additionally, there were concerns that the oncoming recession would result in demand destruction for energy. Of course, supply and demand in the oil markets are pretty tight, resulting in a lot of volatility. Any demand destruction will have a huge negative effect on the price of black gold. Nevertheless, something about all this doesn't sit right with me. Oil seemed to be bottoming somewhere around $100 a barrel, in September of this year, a figure, from what I understand that many economists see as the commodity's intrinsic value. If you look at the first graph, you will notice it had a healthy bounce around $90 around that time, indicating a support level. There seems to be something afoot here aside from fear.

If you look at the three month chart of the Dow Jones (the second one), you will note that recent carnage on the equity markets began around October 1. This is important, because at the end of September, hedge funds were hit with redemption requests and were forced to unload a ton of securities to meet those requests, thus driving down the markets. As a result, a non-secular wave of selling oil has begun in the market as hedge funds were and still are pressured to sell off assets. Like with just about every other securities market in the world, oil has disconnected from the fundamentals and probably will be for at least another month or two. Nevertheless, once some of the fear leaves the market place and investors start feeling somewhat comfortable with the situation, there should be a sharp turn around. Although the contracts for delivery in the coming months will not likely experience much of a rebound, due to the general negative sentiment and fear, contracts maturing later in 2009, in May for instance, will likely end up in the long term once this wave of selling is over. The chinese are still buying cars and America is still amazingly dependent on the stuff.