The truth about high oil prices

I've been writing for two years now about how crude oil (and energy and commodities in general) have risen so high not due to "true economic fundamentals" or lack of supply or an excess of demand, but almost purely due to a frenzy of speculation. Finally, after all of those months, of constantly hearing so much mindless chatter about China and India and Iran and how commodities were only going to go higher, finally, the media has noticed what had been going on, and now quite a few traders, speculators, hedge funds, and money managers are admitting that they had placed very large bets on commodities, and now the folly of those bets is coming home to roost.

The recent decline in the price of crude oil, over $2 today alone, certainly catches your attention.

One problem with trying to estimate where the prices of commodities are headed in the coming months is that it is difficult to assess how much of the recent declines was due to short selling rather than speculators dumping long positions. If speculators really have dumped substantially all of their prior long positions, then we could actually see a dramatic bounce any day now. On the other hand, if speculators continue to hold very large long positions, we could see further significant deterioration in commodities prices as those remaining long positions grow increasingly less attractive to hold.

The real bottom line is that we will see plenty of volatility until commodities gradually drift off the speculators' radar, maybe a year from now.

Right now, commodities are offering more in the way of assured scandals than assured profits. Commodities are no longer a "one way trade" destined to move only higher.

The recent 20% decline in the price of crude oil off the July peak is only some of the froth, the weak hands or short-term speculators. It will take more months of mediocre results or even losses before longer-term speculators finally start to throw in the towel.

There is no fundamental reason for crude oil to be above $35 right now. That means there are still many boatloads of traders, speculators, hedge funds, and in-house trading desks at investment banks who are still enamored by the lure of easy money that simply isn't there any more.

There is a fairly decent article on the recent commodities difficulties in the NY Times by Clifford Krauss entitled "Oil’s Rout Outpaces Its Advance", and that was written before even the rout on Tuesday.

There is also an interesting discussion of commodities by Stephen Roach, Chief Economist at Morgan Stanley, entitled "Commodities as an Asset Class" in which he argues that:

For my money, there is far too much talk about the globalization-led commodity super-cycle.  It gives the false impression of a one-way market, where every dip is buying opportunity.  Yet commodities as a financial asset are as bubble-prone as any other investment.  As is always the case in every bubble I have lived through, denial is deepest when asset values go to excess.  That’s very much the case today.   After three years of extraordinary outperformance, denial over the possibility of a sustained downside adjustment in commodity prices is very much in evidence -- underscoring the time-honored sociology of an asset class that has gone to excess.  Meanwhile, China and US-housing-related fundamentals are going the other way -- setting up increasingly tender commodity markets for unpleasant downside surprises on the demand side of the global economy.  The herding instincts of institutional investors could well magnify the price declines -- when, and if, they emerge.  All this suggests there is still plenty of life left in the time-honored commodity cycle.

The wording of his last sentence is somewhat ambiguous and can be read as either bullish or bearish for commodities.

-- Jack Krupansky