As Oil Nears $100, Look Out Below


Analysts say that if speculators flee the market en masse, prices could drop even more quickly than they've risen

Oil prices are soaring. Having jumped 40% since August, crude prices hit another historic high on Nov. 6, rising to $96.70 a barrel. The factors sparking the $2.72 rally this time: bad weather in the North Sea that could force production cuts, the dollar's continued fall, more violence in the Middle East, and fears that U.S. crude supplies are low. The Energy Dept.'s Energy Information Administration will provide its weekly inventory report on Nov. 7.

But is there a sharp fall just ahead? Analysts say that the oil market looks overheated, and a number of factors could puncture the price bubble. Most important, speculators have played a key role in driving up crude prices this year, and if the trend reverses they'll get out fast. Certainly, global demand remains strong for now. But a number of factors—technical indicators, an economic slowdown, lower demand—could prompt investors to exit en masse.

"Oil prices are in uncharted territory," says Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks commodities hedge funds. "My worry is that if the market tanks, everyone will want out at the same time. The market would collapse, and who knows what the bottom is."

Much Trading Remains Opaque

Speculators have played a growing role in the oil market in recent years (BusinessWeek.com,1/17/07). There are 595 hedge funds that engage in at least some energy trading now, more than triple the 180 funds involved just three years ago. Fusaro estimates the assets involved in such trading total more than $200 billion, up more than 60% from the beginning of the year.

It's tough to get a firm handle on the speculation. A large portion of trading takes place in the unregulated, over-the-counter market. Still, some of the trading in crude oil takes place on the New York Mercantile Exchange (NYMEX), and there the market is approaching a record in terms of the number of crude oil contracts that predict a price rise. Traders have committed to 135,000 contracts—each representing 1,000 barrels of crude—betting that prices will continue to rise. That's just shy of the record 155,000 contracts reached this summer.

Some analysts say that if the number of contracts rises sharply, oil prices could fall. "The exit signal for investors could be breaking through the 150,000 or 160,000 contract barrier," says Joel Fingerman, president of OilAnalytics.net, an energy consulting firm. "At that point investors could feel they're using all their bullets."

For Now, It's Full Steam Ahead

In the meantime however, investment continues to flood the crude oil market, as well as commodities in general. "The mentality now is very bullish," says Fingerman. "As long as money keeps flowing in, people will keep buying [oil] as though it's going to go to the moon."

The optimism has helped the stocks of the oil majors. ConocoPhillips (COP) is up nearly 40% (BusinessWeek.com, 10/26/07) over the past year. ExxonMobil (XOM), Chevron (CVX), British Petroleum (BP), and Royal Dutch Shell (RDSA) have posted similar if somewhat smaller gains.

Still, some analysts say the psychological impact of $100 oil could mark the beginning of a slip in prices. "The professionals will get out of the market at $98.50 or $98.99," says Peter Beutel, president of the energy risk management firm Cameron Hanover in New Canaan, Conn. "They're not going to wait for $100 to materialize."

But is there anything special about the $100 mark? Some experts think not. "The barrier was supposedly $70, $80, then $90, and we're past that. Why would $100 suddenly cause a reversal?" says Stephen Schork, an energy consultant in Villanova, Pa., and editor of the Schork Report, a daily energy newsletter. "$100 is not the death knell to the bull market."

A Correction Is Inevitable

Beutel says that regardless of the exit signal for investors, the oil market is due for a correction. "Historically speaking we see that every time there is a sustained vertical [price] rise, we see a 20% correction," says Beutel, adding that the serious threat of a recession could take 40% off oil prices. "It's a beautiful thing that people forget: The market moves more quickly on the downside than it does on the upside."

It's also possible that ballooning oil prices will begin to fall when demand responds to price signals, as happened in the 1980s. "The uptick in crude hasn't caused the same drag on the economy as it did 28 years ago," says Ray Carbone, owner of the trading firm Paramount Options. "But once we're past all-time highs in oil prices, things could change."

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

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