Why Speculating on Oil Prices Will Eventually Hurt

Fear sometimes makes people react in unpredictable and funny ways. Mounting oil supply fears amid an escalating crisis in the Middle East have led to widespread speculation, ratcheting up oil prices to a 30-month high. At the same time, we are seeing an interesting phenomenon developing.

Notwithstanding the Libyan crisis, which has shown no signs of stopping, oil prices are showing signs of easing, dropping to $111 from $119 a barrel. What exactly is happening?

Saudi Arabia has promised to increase its output to meet global oil demand, but there's no independent way to verify that. In fact, prices started dipping even as the oil minister of Kuwait said that OPEC was "studying" the possibility of increasing production.

My question is: Why should fear and speculation affect oil prices to such a large extent when underlying fundamentals have changed little, if at all? If we look back, the Libyan crisis has been raging for more than a couple of weeks -- with analysts estimating a shortfall of 1 million barrels of production a day -- and yet there hasn't been a veritable shortage in supply.

Speculation, it seems, has more power to influence circumstances than any real, quantifiable action -- at least in the short term. When the crisis in Egypt began, speculation was rife that the unrest would spread to the oil-rich Middle East. Yet, as plausible as it may sound, there hardly seems to be a reason to put all oil-producing economies under a single umbrella.

Per usual, expectations about the future have moved in extremes. Again, while it's true that a revolution has the potential to topple governments, I believe it'd be wiser to show restraint before making absolutist decisions about one's own portfolio and attempting to derive geopolitical solutions to problems that are far more complex than the average investor understands.

For example, in the case of Saudi Arabia, a market of significant consequence for world oil supply, does it really make sense to compare Libya's Gadhafi with King Abdullah of Saudi Arabia when trying to determine which Arab dictatorship is next to fall? Despite internal problems like unemployment, the monarch is a highly respected figure. King Abdullah recently announced benefits to his subjects worth $36 billion. That's just one example.

Still, it would be unreasonable to expect a Libya-like response in the desert kingdom if issues were not addressed. And it would have been impossible for Saudi Arabia to promise an increase in its output to meet the global oil demand if it were battling with domestic problems.

It hasn't been long since fear was driving this market before, either. Fear was the primary catalyst in the oil price hike in 2008. An interesting fact: Average global energy consumption only rose by 2.35% per year from 1994 to 2006. With the recession since 2007, consumption hasn't significantly increased since 2006, too.

So what exactly was behind oil prices going up from $25 to $147 a barrel since then? Either the stuff was massively undervalued in '94 or it is massively overvalued now. As you'll recall in 2008, savvy traders in the energy futures market were mainly responsible for exploiting short-term panic and emotionally driven trading. A senior vice president of ExxonMobil (NYSE: XOM  ) had called for a crackdown on such speculation then. But memory is short. Now we're looking at the same issue again. And once again, we're looking at a market that is being pushed not by fundamental reality, but by emotional trading and short-term thinking.

How have oil stocks responded in general in the past month? Well, this should hardly come as a surprise. While the S&P 500 registered a fall of 1.65%, every major company from the sector has seen a rise in its share price. ExxonMobil recorded a 2.8% increase. Chevron (NYSE: CVX  ) shares rose by 7.7%. Royal Dutch Shell's (NYSE: RDS-A  ) (NYSE: RDS-B  ) shares rose by 4.5% and 5.7%, respectively. British Petroleum (NYSE: BP  ) stocks gained 5.5% while ConocoPhillips (NYSE: COP  ) rose by almost 14%.

So will investing in these shares simply to cash in on this sudden crisis prove worthy in the long run? Well, ask Warren Buffett. Buffett brought a large amount of stock in ConocoPhillips in 2008 when oil and gas prices were peaking, but by his own admission never anticipated the "dramatic fall in energy prices" that was to follow some months later. To put it into perspective, in the words of Fool Anand Chokkavelu, this was one of Buffett's few large investing missteps.

This is where speculation hurts. Because it does not anticipate based on fundamentals; it is more like a sophisticated form of gambling. I am not saying that history will repeat itself in exactly the same way, but it's good to learn from examples. It would prove to be Foolish if one can take each oil stock on an individual basis before going ahead in this volatile sector.

Isac Simon does not own shares of any of the companies mentioned in this article. Chevron is a Motley Fool Income Investor choice. The Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On March 16, 2011, at 12:10 PM, philipelewis wrote:

    This is the same blah, blah, blah that is repeated so often everyone assumes it is true without questioning. People who are unhappy with the direction markets are moving must always find a scapegoat and politicians are always more than happy to string 'em up in return for votes.

    If I am in charge of keeping a $10 billion refinery (some are more than that) stocked with crude I am going to be pretty anxious by stuff that is happening in the oil markets today. One second of interruption in crude supply would be an unmitigated disaster for these guys, their companies, and their shareholders. Put ten of these guys on a trading floor and they will bid the price up. It's a risk premium and it is based on reality of what is going on in the world today. It is not a speculation premium.

    Can speculation impact the market on given day? Sure. Did speculation drive up the price from $25 to $140? No way. But speculators (whoever they are...its always best to have villains who are nameless, shapeless, and hide in the shadows) sure are convenient to blame.

  • Report this Comment On March 17, 2011, at 11:45 AM, rfaramir wrote:

    You ask: "So what exactly was behind oil prices going up from $25 to $147 a barrel since then? Either the stuff was massively undervalued in '94 or it is massively overvalued now."

    Another option is that the value of the dollar is less now than then. A lot less. And oil isn't $147, that was the brief spike price in 2008.

    Here's one version of the True Money Supply through 2009: http://mises.org/content/nofed/chart.aspx?series=TMS

    Add in QE(1) and (2) which raised the supply further and you can see exactly why the price is so high. More dollars chasing the real commodity.

    And as people become aware of this fact, they will anticipate it, ending with hyperinflation if the money supply increase is not stopped, or high interest rates if it is stopped (like Volcker in the '80s).

  • Report this Comment On March 18, 2011, at 1:58 AM, isacsimon wrote:

    @philipelewis

    I respect the argument that a moment's interruption in supply can cause disaster, however, by bidding up the prices one cannot actually control supply in the long run. The reasons affecting supply are entirely different.

    Also one must realize that world oil reserves were much higher in 2006 (in the lead up to the spike) than it were in '94.

    -Isac

  • Report this Comment On March 18, 2011, at 2:31 AM, isacsimon wrote:

    @rfaramir

    This is a valid point. The value of dollar has gone down and this inevitably causes a price rise.

    However, the real rise in prices started from January 2007 when oil was priced $52/barrel, peaking in July 2008. During this period, the dollar had actually strengthened due to the credit crisis, following which a correction took place and prices fell to $36/barrel in January 2009.

    -Isac

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