Get Out of Logic-Defying Oil While You Can

Discussion in 'Wall St. News' started by S2007S, Jul 7, 2008.

  1. S2007S


    Good article,

    Anyone ready to see oil back below $120, maybe even $100, I sure am.

    People will say that this time the commodity "bubble" is different" every "bubble" is always different, RIGHT???







    SOME THINGS I know, some things I don't know. One thing I don't know is why the price of oil is as high as it is.

    Ignorance is no basis for an investment strategy. But if you can reasonably and rigorously dismiss every possible good reason why oil is soaring to all-time highs, then it's probably time to sell it.

    Over the years I've been writing this column I've made some great oil calls. In October 2005, in the immediate aftermath of Hurricanes Katrina and Rita, I said to short it because I knew the supply shock from the storms wouldn't last. That was when crude oil hit what seemed at the time like a ridiculously high price of $62 per barrel. Today that price would seem like a bargain.

    Then I said to buy oil in January 2007. By then the price had fallen to $56 per barrel, so my call from a year earlier ended up being vindicated. My rationale for buying in early 2007 was that I forecasted — correctly, as it turned out — that inflation was about to surge, and I assumed it would take oil and all commodities along for the ride, which it did.

    But in March of this year, after the Fed's rescue of the world's financial system after the collapse of Bear Stearns, I said I didn't want to own oil or other commodities anymore. My bet was that the Bear debacle would mark a turning point for the Fed. I guessed that soon afterward the rate cuts would stop, and soon enough the Fed would turn to rate hikes. (As Wednesday's FOMC statement hinted, that's exactly what's going to happen — although the timing is very much up in the air.) That means inflation will start to taper off, so my reason for owning oil was gone.

    Oops. Double oops. Oil has risen almost 30% since then, and I missed it.

    And what really puzzles me about it is that I was right about inflation. Oh, yes, I know. Suddenly inflation is at the head of everybody's worry list. But that in itself doesn't surprise me. I've been warning about inflation for five years while everyone else was saying it was impossible. So now that it's just about over, everyone's finally latching onto the idea.

    I know it's over because all the things that warned me about it in the first place are starting to tell me to stop worrying. Gold, the best inflation indicator of them all, is off 13% from its mid-March all-time highs. The dollar, the second best indicator, is 3% above its mid-March all-time lows. Spreads on inflation-indexed Treasury bonds have collapsed. The yield curve has flattened. It's unanimous.

    Well, almost unanimous. There's oil. Up 32% in just a little more than three months. Why? It's not because of inflation. That's been part of the oil story for the last five years, and Thursday's surge was probably connected with some disappointment that the Fed isn't going to be even more vigilant about inflation. But there's no credible inflation scenario at work in the last three months to justify a 32% leap in oil prices.

    And it's not because of price-gouging, greedy oil company executives, or any of that populist tripe that has become the daily fodder of Senate and House investigative hearings. And as I wrote here several weeks ago, it's not because of commodity index funds buying up all of the world's oil. That's just plain silly.

    I suppose it might be good old-fashioned speculation. Maybe oil is at $140 for the same reason that the Nasdaq was at 5,000 in March 2000. That is, for no reason at all except that it just is. Who knows? That kind of explanation is no explanation at all.

    I know it's not because there's a "dollar crisis." As I mentioned earlier, over the last three months while oil has soared the dollar is up — not down.

    I know all the stories about rising demand in China and India and everywhere else. And I've heard all the stories about "peak oil" — the idea that we're simply running out of this exhaustible resource, and that we're approaching maximum production and about to enter a permanent time of scarcity. I wrote here in early 2005 that I thought that was nothing but a scare story.

    But even if it is true, is there some particular reason why the oil price should go crazy exactly now? It's not a surprise that China and India are industrializing. And it's not like all the wells are just suddenly going dry right here and right now (if at all). And there aren't any shortages now. I don't see any lines around the block waiting at gas stations. Do you?

    Maybe the surge in the oil price is related to the risk that the U.S. or Israel will bomb Iran to turn back their purported program to develop nuclear weapons. That could severely destabilize the Middle East and interrupt oil production and shipping for a considerable period. There have been ominous hints about it from both Washington and Tel Aviv, and with a presidential election coming up, there's a greater than normal chance that the current powers that be might decide to say "bombs away" while they still can.

    One clue on that is to look to the political futures contracts that trade online at Intrade. Their prices can be used to infer probabilities of various events, and in the past they've been uncannily accurate in predicting elections. Right now they are assigning an approximately 30% chance of a strike against Iran by the end of this year. That's an uncomfortably high number. That said, it was even higher six months ago, when the oil price was considerably lower.

    None of these explanations is especially convincing. So if there's no good reason for the oil price to be so high, maybe it shouldn't be so high. Maybe the thing to do with oil is to sell it.

    That's a hard thing to do. It takes real guts to get in the way of a runaway train and bet it will reverse before it annihilates you. Even absent that fear, it takes a certain kind of courage to invest differently than everyone else. And right now everyone is long oil — or, at least, energy stocks. Those are "what's working," as unprincipled investors are fond of saying to rationalize to themselves their blind trend-following. So I say take the other side of the bet: Sell it.

    At the very least, if you're one of the many people who've made a bundle in energy stocks, take a little off the table. Don't get greedy. Remember, nobody ever went broke taking profits.