Oil Price Decline Bubble?
Explanation number one is simply dead wrong. There could be some truth in explanation number two, but it is probably not the entire story. As I've tirelessly tried to explain, a speculative bubble is certainly a possible scenario, but it requires symptoms in the form of rising inventory levels. Because unless demand (and supply) is completely inelastic (which is an unrealistic assumption), any price not representing fundamentals can only be sustained by increasing inventory levels. And there was simply no evidence of rising inventories at any time. It is possible, especially given the limited degree of truth in explanation number two, that had oil stayed at the peak of $147, then inventories would have started to rise. But that is only a possibility, and even if it were true, it doesn't mean that prices like $130 or $140 would be justified.
Explanation number two could have some truth in it, as we see weakening economies in Europe and Japan, something which clearly would hurt demand. Also, the strengthening dollar represents a form of shift in fundamentals for the dollar price of oil (although it represents a negative shift in fundamentals for the price of oil in other currencies), but there are reasons to believe that this rally could be related to the third explanation discussed below.
The third explanation is that the recent decline could be a bubble, triggered by recent short-selling rules. As Merrill Lynch consultant David Bowers explain, the decision by U.S. authorities to enforce a ban on short-selling on 17 banks and financial institutions has set in motion a massive short-squeeze forcing hedge funds to unwind their short positions in these stocks. And since these short positions were used as funding for long positions in oil and other commodities, the unwinding of these short positions in banks also meant unwinding the long positions in oil. The unwinding of these short positions in financial stocks also at the same time forced these hedge funds to buy dollars (as financial stocks are bought back with dollars), which contributed to the dollar rally, a rally which further depressed the oil price.
Combined with the factors I discussed in my recent post about financial market behavioral patterns, this is the explanation for the recent decline in oil. But if the old price wasn't significantly inflated by speculation, and if most of the recent declines reflect speculation, then it follows that the current price could be significantly depressed by speculation. Probably not entirely, but to a very large extent.
The first tentative indication that this could be true came from the significant drops in inventories of petroleum products last week (the week ending August 8). While crude oil inventories only fell 0.4 million barrels, distillates (diesel and heating oil) fell 1.7 million barrel and gasoline fell 6.4 million barrels. Given that these numbers fluctuate a bit from week to week, one week's decline is not conclusive evidence that prices are too low. We'll have to wait and see what happens in the coming weeks. But if inventories continues to fall, then we'll have to conclude that the current price is too low, and that the only speculative "bubble" is the latest decline.