Oil Prices: It’s Not About the Oil

Crude oil prices are again breaking records, but not because of real issues with supply and demand

…What’s driving oil prices? Economics 101 says price is determined by the balance of supply and demand. But when it comes to the oil market, fears and expectations have been trumping economic rules and carrying the day. “These movements have nothing to do with supply or demand, or with oil for that matter,” says Fadel Gheit, senior analyst with Oppenheimer (OPY) in New York. “There is more exaggeration than ever before in this market.”


The exaggeration comes, in part, from a marked increase in speculators entering the oil market in recent years (BusinessWeek.com, 1/16/07). From commodity hedge funds to institutional investors seeing potential profits amid the volatility, the oil market has become ultrasensitive and can easily jolt in either direction. In essence, oil’s headline-topping surges and retreats over the past year are not the result of market fundamentals but of oil traders’ minute-by-minute reflexes. Each piece of news lets traders anticipate threats to future supply and demand, bidding up or down the price as they take long or short positions.

Worries about the U.S. economy caused prices to sag for much of January, even after crossing the $100-per-barrel threshold on the first trading day of the year. Betting the economy would continue to keep prices down, hedge funds were shorting oil. But since Feb. 6, investors changed their strategy and covered their short positions, causing prices to jump more than $11 per barrel. “Two weeks ago we were focused on the economy falling apart and demand destruction,” says Phil Flynn, analyst and vice-president of the brokerage firm Alaron Trading in Chicago. “Then someone flipped the switch and started worrying about adequate supply.”

Business Week