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Oil’s Rise: Speculation or Fundamentals?

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Continuing with this blog’s ongoing energy and policy discussion, an article from John Mauldin, at Thoughts from the Frontline, has some interesting thoughts on the issue specifically dealing with oil. He looks at how index speculators have increased the amount of dollars chasing commodities in long term positions and whether this really effects the price by looking at oil fundamentals. Mauldin then looks at an interesting scenario, which he sees developing in the near-term:

Many developing countries subsidize the price of oil to their citizens, so they do not feel the pain of higher oil prices. But the headline of today’s Financial Times is that Asia is finally getting ready to cut their subsidies as oil rises to $135. The awareness that they need to allow market conditions to prevail is finally being acknowledged, as they cannot afford the subsidies. This is going to help drive down demand for oil over time.

As demand starts to fall, let’s remember that the storage facilities for oil waiting to be refined are a finite item. If all those tankers end up needing to find a home at the same time, even as demand for oil is going down, you could see the price of oil go down rather quickly in the short term.

If you are leasing tankers to deliver oil that is already hedged in price, you want to get it to port as soon as possible so that your lease payments stop as soon as possible. You only hold it on the high seas if you think the price is going up by more than your carrying costs (the cost of money and leasing the tanker). If you start to lose money, you sell your oil on the futures market and get it to port as fast as you can.

Now, here is where it could get interesting. Oil is the biggest component of the commodity index funds. If oil drops and looks likely to go lower, then the massive buying of these funds we have seen in the past few months could dry up. As Dennis Gartman says, it takes a lot of buying to make the price of something to go up, but it only takes a lack of buying to make it go down. And if there is net selling?

For the entire discussion, it is certainly worth looking at. In the end, he still sees oil at a higher price than the $130 range it reached last week.

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Written by walonline

May 27, 2008 at 3:57 pm

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