Evidence Shows Oil Price Decline Was Driven By Speculation
This view is now supported by evidence from inventory accumulation. If the price of oil is too high relative to fundamentals then inventories will rise. If on the other hand the price is too low then inventories will fall. The basis for using this method is simply that if demand is higher than supply then this will result in lower inventories, and similarly if supply is higher than demand then this will result in higher inventories.
And inventory data from the EIA shows significant declines in the inventory level of not just crude oil but oil-based products like gasoline and distillates (diesel and heating oil). During the 5 weeks since my post, crude inventories are down 4.8 million barrels, distillates inventories are down 2 million barrels and gasoline inventories are down a full 18.2 million barrels. While it is not unusual for gasoline and crude inventories to fall this time of the year, particularly gasoline saw an unusually large decline. Moreover, usually distillates inventories are up substantially this time of the year, but in recent weeks they have been falling.
At this point, I can imagine that many of you would object that the numbers were distorted by the effects of hurricane Gustav (Interesting, BTW, with a Swedish name for a tropical storm). This is to some extent true, but there is more to it than that as total petroleum inventories fell a lot more than during the comparable period in 2005, after hurricanes Katrina and Rita. Moreover, to the extent the hurricane reduced oil supply it should in fact have a price increasing effect as it will require higher oil output relative to demand in the future to rebuild inventories to normal levels.
So, it should be very clear that the price of oil has been too low in recent weeks. That does not necessarily imply that prices will rise as the latest financial turmoil could hurt demand, and thus perhaps bring about the elimination of the gap between the actual price and the equilibrium price by lowering the latter rather than by raising the former. But it does mean that the price so far has been too low and it means that even if the equilibrium price fall there won't be any room for further declines (unless the reduction in equilibrium price is really dramatic).