Could Oil Prices Be Headed for a Dip?

The reasons for oil's climb above $100 a barrel are well-known, including rising demand from fast-growing Asian economies, along with the risks of continuing geopolitical turmoil in North Africa and the Mideast. But as my colleague Charles Wallace recently reported, a significant premium in the price of oil stems from speculation, which has recently skyrocketed as traders and fund managers seek out commodity and global growth plays.

With oil swinging from around $50 per barrel in 2007 to $145 a barrel in 2008 and then plummeting to $32 a barrel in 2009, this huge increase in speculative trading has led to tremendous volatility.

And that leads to this question: could oil slump sharply, despite all the reasons typically given for higher prices, mostly as a function of the speculative trade?

Speculation Does Not Equal Endless Bull Markets

The recent explosion in oil speculation can be seen in the following two charts. The first depicts volume -- the total number of futures contracts traded -- and the second charts open interest, the number of contracts outstanding. This data is from the U.S. Commodity Futures Trading Commission (CFTC), which regulates the futures markets for commonly traded commodities.

The chart below, showing oil price history, illustrates how massive increases in speculation do not guarantee endless bull markets: highly leveraged speculative trades can quickly reverse course when sentiment changes. Rising volume and speculative interest increase volatility, as extremes of sentiment are reflected in large positions being taken on the long (bullish) or short (bearish) side.

Notice both volume and open interest rose sharply from 2006. Since then, oil rose in a bubble-like spike to $145 per barrel, and then subsequently crashed back to $32 per barrel a few scant months later as the global recession took hold. It has since tripled to over $100 barrel.

The next chart might give the oil bulls pause: the Commitment of Traders (COT) commercial traders' long and short positions in oil. Many investors and analysts look at COT for three basic categories of traders: small speculators, the large speculators -- such as hedge funds -- and commercial traders (typically global corporations that hedge against big swings in commodity prices), and large financial institutions' trading desks.

A short position by a large firm, in other words, might act as "portfolio insurance" or a hedge against volatility. Thus a firm that owned long contracts for oil might buy a short position to protect against losses should oil fall.

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Note how the short interest of the commercial traders rose above long positions in the buildup to oil, peaking in 2008. As the price of oil marched ever higher, commercial traders sought out more protection in the form of short positions.

But higher short positions might also reflect trading bets that the high price won't last, and that a reversal is imminent.

Recently, long positions have declined while short positions have jumped. The spread between the two has widened to the largest gap in the past decade. Clearly, major players are betting (or hedging) that oil could drop precipitously.

Fearful of a Decline, or Betting on It

A recent report from Goldman Sachs concluded there is about $10 per barrel of speculative premium priced into oil. That suggests if the speculation declined, oil might fall at best $10 a barrel. From this point of view, oil is still priced mostly by fundamental supply-and-demand issues, and speculation adds no more that about 10% to the cost at today's price of $104 per barrel.

Given an expected rise in demand for oil -- especially as Japan replaces the electricity generation capacity it recently lost, as a result of the earthquake and tsunami that damaged the Fukushima nuclear reactors --Goldman Sachs estimates there is no more than $10 a barrel downside in the price of oil.

Perhaps, but estimating the consequences of increased speculation is not a precise science. Given the above chart, it seems evident that some of the biggest players aren't taking any chances. The unprecedented spread between long and short positions suggests somebody is either fearful of a major decline in the price of oil -- or is actively betting on it.