Editor’s Note: Are market fundamentals to blame for sky-high crude oil prices? Of course not, says Andrew Gordon. It’s the tens of billions of dollars pouring into the oil futures markets are. Sure, demand is high – but the high-end costs of producing oil are $70 max, so a barrel of the black goo should cost about $110.

The price of oil climbed 38% between April and June, the biggest quarterly increase in nine years. Today oil stood at $141 a barrel, a slight drop from yesterday’s sky-high $143.

News from the International Energy Agency that supplies may not keep up with demand through 2013 and reports that Israel will probably attack Iran look set to push prices even higher.

Of Course It’s The Speculators

Andrew Gordon

It’s just plain wrong that oil speculators are having no effect or only a minor one on the price of oil.

The arguments that have hoodwinked smart people into believing that oil prices are justified are so flawed, it makes me wonder what kind of mass hypnosis has come over us. The main argument I’ve heard time and again is (in its logical construct) very similar to this one…

Suppose I’m fat, and I go to Mickie D’s every evening and eat five bacon double-cheeseburgers with five helpings of fries. My sister is also fat but she doesn’t eat fast food. So that’s proof that pigging out at Mickie D’s has nothing to do with my being fat. It must be another reason and the reason is obvious: my metabolism.

And so the argument goes with the oil market. It’s feeding on tens of billions of dollars pouring into the futures market and getting fatter and fatter. For example, five years ago, the commodity futures market had $13 billion invested in it. Now it has $260 billion. Eighteen years ago, only 13 percent of open interest in oil futures was long (betting that oil prices would go up). Now, 58 percent is invested long.

But it makes no difference – so they say – and you know why? Because other commodities like coal and cobalt that aren’t on a tradable index are also experiencing dramatic increases in prices. And because oil supply is tight and seemingly getting tighter.

What’s wrong with the “thinly traded commodities are also high” argument? The same thing that is wrong with “my sister is also fat” argument. Just maybe (do you think?) “my sister” would be even fatter if she hung out at Mickie D’s with her brother.

As high as cobalt and rice are, does anyone doubt that if they were traded by long-only commodity index funds or ETFs to the point that tens of billions of dollars were pouring into the futures market and betting long, they’d be even higher right now?

“It has to be my metabolism instead” is the same as saying “it has to be market fundamentals instead.” It would be silly to discount fundamentals (as it would be silly to discount metabolism). But by solely focusing on fundamentals (or metabolism), the feeding frenzy is ignored. And that’s silly too.

It’s not an either-or kind of argument. In fact, the price of crude only makes sense when you take both into consideration: lousy fundamentals and a speculative frenzy. One pushes the price up to a certain level and the other pushes it up higher.

Yes, it’s absolutely legit that oil prices are going up. Here are my eight biggest reasons for crude’s price rise.

1. With a global oil shortage expected to persist into the future and perhaps get worse, prices should be at record highs.

2. Robust global demand is causing oil prices to rise.

3. Oil has been rising on the weak dollar.

4. There’s been a slew of bad news recently – from strikes and pipeline attacks in Nigeria to Libya threatening to reduce crude production – which is driving up prices.

5. The oil majors are producing less not more crude.

6. The oil majors are producing more crude than they’re finding in the ground.

7. Demand is slowing but oil production is falling faster than demand is slipping.

8. There’s no immediate alternative to oil consumption.

But…

Should oil prices have gone over $140? And should they very possibly be going over $150-170 in the coming weeks? No way.

Not when the high-end costs of producing oil is in the $55-70 range. Sure, there’s been a worsening of the supply-demand equation, but it’s been marginal. I believe the price of oil should be around $100-110.

The reason why it has gone WAY UP is the speculative oil bubble. Some hedge funds dove in and shorted on the fundamentals but forgot that they were at the same time creating a speculative monster. They weren’t just investing in the oil market. They were becoming the market. Without that critical realization, they underestimated the top of the market and were punished … forced to cover their bets … and suffered staggering losses.

On the other hand, those who keep betting that oil prices will rise are raking in the dough. Bad news in the oil patch may mean worsening fundamentals. But how bad … for how long …  is it part of a pattern or not … exaggerated or not … with immediate or long-term implications … all the color has been bleached out because it doesn’t really matter anymore.

Bad news now serves a simple purpose. They are “buy” signals for speculators to ply the market with more money. And what about good news – like the 200,000 barrels per day of extra production Saudi Arabia announced two Sundays ago? In a bubble, good news that could drive prices down is either ignored or turned into bad news. So the bubble can do what bubbles do: expand.

That is what happened to the Saudi announcement. It was greeted with a dismissive “not enough” or “disappointing.” We can expect more of the same in the future — until the bubble bursts.

And, one of these days, it will burst. Because that is also what bubbles do.

Invest well,

Andrew Gordon

P.S.  To let me know what you thought of today’s article, send an e-mail to: feedback@investorsdailyedge.com.

[Ed. Note: With a bear market looming, it’s more important than ever to select safe investments that produce monthly dividend income. Click here to learn about Andy Gordon's INCOME service that selects the best dividend-paying stocks available.]

Source: Of Course It’s the Speculators