Do 2 days of oil price declines signal a trend? No, but . . .

McClatchy NewspapersJuly 16, 2008 

Oil prices fell sharply Wednesday for the second consecutive day, and the cumulative drop of $10.58 a barrel for crude has sparked hopes that this year's steep rise in prices finally may be reversing.

Contracts for next-month deliveries of oil, called futures contracts, settled down $4.14 to $134.60 in Wednesday trading on the New York Mercantile Exchange. That was on the heels of a more than $6 drop a day earlier.

It's too early to say whether the sudden drop reflects the start of a massive selloff that could bring down oil prices on a sustained basis. But oil analysts think that the trend will be down soon, whether or not this week marks the turning point.

"Two days does not a trend make. But obviously the chances to put in a top (ceiling) are very good right now, because it is obvious to everyone who is looking that we are seeing clear signs of demand destruction for oil," said Phil Flynn, an energy analyst with Alaron Trading, a commodities brokerage in Chicago. "I think there is a certain realization that we may have hit the point of pain where demand is going to go away."

Economic theory holds that prices can rise only so high before customers are no longer willing or able to pay for a product, a phenomenon called demand destruction. In the United States, the world's largest energy consumer, the high price of gasoline — a result of high oil prices — has led to a 2 percent drop in gasoline consumption this summer and a 2.6 percent drop in oil demand this year.

The coming weeks should signal whether oil prices remain volatile, swinging $10 or more up or down in a period of days, or whether they're on the way down sharply. Flynn and others suggest that traders are watching for psychological break points: $135 a barrel and higher for an oil rally to resume or less than $130 for sharper downward corrections ahead.

"I think we are closer to a turning point. I don’t know if this is the turning point," said Antoine Halff, the director of commodities research for Newedge USA, a futures market brokerage.

But the clear expectation is that the U.S. and global economies will slow significantly, and that means demand for oil will fall off.

"The contraction in the U.S. is looking to be much steeper than earlier assessments. Demand destruction looks pretty lasting," said Halff, adding that Europe and the United States are in periods of unusually slow growth and big developing nations such as China and India are expected to experience some slowdown too. "You see significant decrease in demand across the board."

There doesn't seem to be just one thing that's sending oil prices sharply lower. The decline is due to a combination of factors.

The spark Wednesday was a government report showing unexpectedly high inventories of oil. A drawdown was expected, but instead inventories grew by 3 million barrels for the week ending Friday.

The biggest factor appears to be Federal Reserve Chairman Ben Bernanke's congressional testimony Tuesday and Wednesday, in which he warned of significant risks of a protracted economic slowdown that would create a global slowdown.

"Anybody who doesn't think that the overall financial conditions and the Federal Reserve don't have an impact on oil prices, well, the charts don't bear that out," said Flynn, the Chicago analyst. "The Fed is not going to let oil go up without trying to fight inflation by raising interest rates."

If oil prices stay high, the Fed is likely to raise interest rates, possibly tipping the economy into recession and surely quashing demand for oil more than the high prices have to date.

Should the two-day drop in prices be the start of a bigger selloff, the sharply falling prices would take pressure off the Fed for rate hikes.

If a slump in oil prices has started, the question becomes how far they'll drop. Crude oil is still up more than 80 percent since last July.

"I think somewhere around $100 (a barrel) sounds reasonable," said Halff, pointing to expected new Saudi oil supply and a slowing global economy.

Continued turbulence in financial markets may keep prices high, however, as investors still see oil and other commodities as a haven.

"If there is a sense in the United States that we're not going to have a financial meltdown, and demand stays weak, we could see oil back below $100 (a barrel), not that it will necessarily stay there," said Flynn, estimating that today’' oil prices reflect a $30-a-barrel "financial stress" premium.

This disconnect of prices from traditional supply and demand signals is why Congress is studying ways to limit trading in oil contracts by financial players who have no intent of taking delivery of the oil, and why airlines are e-mailing their customers with campaigns to have citizens lobby Congress to end excessive speculation in oil markets.

The debate over oil speculation is breaking down along party and industry lines. Democrats and airlines say that insufficient regulation of oil trading is to blame for the high prices. The Bush administration, congressional Republicans and big financiers say that insufficient oil supplies are to blame and more drilling is needed.

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