The Oil Bubble Loses Some Air

After weeks of setting records near $100 per barrel, oil prices retreat. Analysts wonder whether this is the start of a bigger tumble

by Moira Herbst

The hot money that tested crude oil's highs is staging a rapid retreat. Oil futures have dipped 5.3% over the past two sessions, settling at $91.71 per barrel on Nov. 13, less than a week after hitting a trading high of $98.62 on the New York Mercantile Exchange. That record turned the never-seen milestone of $100 (BusinessWeek, 11/19/07) into a distinct possibility.

Now those same players are finding compelling reasons to bail out of West Texas crude. On Nov. 13, 30% of the options contracts to buy oil at $100 expired—and hedge funds and other speculators decided to collect their profits.

"They got exposure to the idea that as the market tests $100, everyone is going to sell oil, and the options would expire meaningless," says Adam Robinson, an analyst with Lehman Brothers (LEH). "They thought if the speculative rally is set to end, perhaps they should get out now. They didn't want to be stuck holding the bag."

Volatility Is the Norm

The December options expiration came the same day the International Energy Agency trimmed forecasts for next year's global oil demand by 300,000 barrels, a reaction to the steep prices. The IEA predicts global oil demand in 2008 will be 87.69 million daily barrels, down from previous estimates of 100 million per day, owing to slower demand in the developed world.

"The bottom line: more sellers than buyers," says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. "The question now is whether this is a retracement [or temporary correction] in a longer-term bull market, or if steeper corrections are ahead."

Oil prices have nearly doubled since the beginning of the year. Supply and demand haven't shifted radically in that time, but trader and investor expectations have. Speculators, many of them hedge funds and large investment banks, have flooded the commodities market, bidding up the price on any news of potential supply disruptions or stronger demand. "I don't believe $100 oil is the new normal; volatility is the new normal," says Tom Kloza, chief analyst for the Oil Price Information Service, in Wall, N.J.

Idle Speculation?

The question now surrounding oil above $90: How much of that price is driven by speculative momentum and unsupported by fundamentals? The answer after the Nov. 12-13 sessions: at least $5. Lehman's Robinson says hedge funds holding contracts for $100 were discouraged by the drop in oil prices Nov. 12, and concluded that a jump to triple digits in a single session was impossible.

Some analysts say the recent deflation in oil prices is only the beginning of a potential free fall. "Oil prices have risen ridiculously high ridiculously fast because of speculation," says Fadel Gheit, senior energy analyst for Oppenheimer Holdings (OPY). "It has nothing to do with fundamentals. It's a bubble, and the question is not if it'll burst—it's when?"

Herbst is a reporter for BusinessWeek.com in New York .