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Oil: It's Back To Supply And Demand


Last July, when crude oil was surging toward $80 a barrel, the talk of a new reality in the energy markets hit a fever pitch. Some said China and India would so voraciously suck up supplies that we might never see $50 a barrel again. Others noted that the nations that make up OPEC had finally figured out how to put the screws to the West for good, emboldening Iran and Venezuela to send prices higher with a mere rattle of their sabers. The "multi-decade supertrend" mantra echoed through the canyons of Wall Street.

Then oil crashed, touching $50 in January, 35% off its peak. Since July, in fact, crude has underperformed the stock market by 48 percentage points. All this while China's oil-thirsty economy remains white-hot, Iran is barring nuclear inspectors, Venezuela is booting foreign oil investors, and Russia is putting the energy squeeze on neighbors.

So what happened? Call it a return to normalcy. The speculators and latecomers who bought into the new-paradigm argument suddenly turned tail--and traditional drivers of the oil market reemerged in force.

The biggest: old-fashioned supply and demand. Last week, prices fell when the Energy Dept. said it had tallied just under 322 million barrels of domestic crude oil stockpiles, a 6.8 million-barrel increase for the week and 9.3% more than the five-year average. Then, on Jan. 23, prices rose after the U.S. announced plans to double the size of the strategic petroleum reserve during the next few decades--promising, in essence, to take supply off the market. But that wasn't enough to demoralize the oil bears, who growled the very next day after another report showed brimming stockpiles. The upshot: The self-correcting forces of Economics 101 still apply to oil. "Cycles come and cycles go," says Oppenheimer & Co. (OPY) oil analyst Fadel Gheit. "This is a commodity. There is no physical reason for it to have gone to $80." Gheit and others say the true supply-demand equilibrium for oil is closer to $45 a barrel.

PLUNGE IN FUTURES

At least for now, the inventory glut has derailed the speculators' easy money story. Philip K. Verleger Jr., an Aspen (Colo.) energy economist, witnessed the risk-free bet of financial players buying oil cheaply on the spot market, storing it, and contracting in the futures market to sell it later at a chunky premium. "The investment banks were able to lock in 50% and 60% rates of return where they owned storage facilities," he says. Now, the pendulum has swung the other way. According to data from the Commodity Futures Trading Commission, speculators' total position in crude oil futures plunged from a "net long" (or bullish) position of 75,000 contracts in August to a "net short" (or bearish) position of 2,032 contracts last week. One trader posits that the ferocity of oil's recent fall means more of his peers are subscribing to the idea that "someone is in trouble." He adds: "I wouldn't be shocked if we had another Amaranth [Advisors] come out of this," referring to a multibillion- dollar hedge fund that collapsed in September after making an ill-timed bet on natural gas futures. Says veteran oil industry analyst Charles T. Maxwell of Weeden & Co.: "Usually, this goes to excess. Someone gets hurt, and more people will say it's time to pack their bags and go home."

Other financial institutions are scrambling to adjust. Fidelity Investments' $69 billion Contrafund (FCNTX), the largest mutual fund at the country's largest fund company, dumped energy laggards that contributed to the fund's having trailed the Standard & Poor's 500-stock index by four points last year. Firms such as Deutsche Bank (DB) and Barclays PLC (BCS) that lent their names to oil-heavy exchange-traded funds (ETFs) must now contend with the asset class hitting a two-year low. "People were piling into commodity ETFs," says Bill O'Grady, assistant director of market analysis at St. Louis-based A.G. Edwards & Sons (AGE). "Now, the 25% pullback is scaring the heck out of them."

For all the fast action, O'Grady's statistical research finds that the recent commodities bull market was, contrary to conventional wisdom, very much cyclical--and in fact was a tiny blip within a 100-year trend of falling commodity prices (adjusted for inflation). "The idea that this commodities run would be permanent kept resonating with investors," he says, "until it didn't."

Another oil-market driver seems to be returning to form: OPEC, which has lately demonstrated its classic inclination toward ineffectiveness. According to Bank of America Corp. (BAC) research, OPEC export revenue should plunge to about $84 billion by the second quarter of 2007, down from a $126 billion peak in the third quarter of 2006. To compensate for the unexpected shortfall, OPEC has been selling U.S. Treasuries at the fastest clip in more than three years. Last week, the Saudi oil minister voiced opposition to cartel members' desire to hold an emergency meeting to address oil prices. OPEC's late-2006 pledge to cut by 1.2 million barrels per day starting on Nov. 1 and by an additional 500,000 barrels before Feb. 1 has fallen on deaf ears, primarily because the cartel hasn't yet made good on the first part of the pledge. "How can you cut more if you haven't even fulfilled your first production cut? OPEC can't just jawbone the market anymore," says Gheit.

It's anyone's guess where oil prices will go from here. Not that this is stopping the supply-demand school from enjoying a bit of vindication. "There were times when I felt like the class clown," says Benchmark Co. oil and gas analyst Mark Gilman, of the way his skepticism was received when oil hit $78. "All of a sudden my thoughts aren't so funny.

By Roben Farzad, with Peter Coy


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