Oil May Have Peaked—For Now

05/29/2008 12:00 am EST

Focus: COMMODITIES

Howard Gold

Founder & President, GoldenEgg Investing

That loud noise you heard just before the Memorial Day holiday may have been the price of crude oil cracking.

Having briefly crossed the $135 barrier, crude is now struggling to stay above $130. And it looks as if the path of least resistance is down.

Why? Reality has finally collided with the wishful thinking of raging oil bulls-both active crude buyers and so-called speculators-who were clearly behind the recent spike in crude prices.

That surge-in which West Texas intermediate crude shot up nearly 40% this year-has been described as "parabolic" by none other than George Soros, no stranger to speculation himself.

Because although supply will remain tight for years-something we first said last April when crude was in the mid-$60s-demand is dropping like a stone as US motorists have gone on strike against skyrocketing gasoline prices. I wouldn't be surprised to see a slowdown in demand from China or India later this year, either.

And the recent unanimity among traders that oil has nowhere to go but up is usually a sign of the pride that goeth before a fall.

Underlying all of this, of course, is supply and demand.

The world's supply of oil has been pretty stable, says Mary H. Novak, managing director of North American Energy Services for Global Insight. And there are many obstacles to increasing it. 

Only about one in every five barrels of crude can be drilled by the world's major oil companies; the rest is controlled by state-owned companies that have their own economic and political agendas.

Geological barriers, environmental restrictions, and technological impediments have kept potential fields from being exploited. And as older fields like Cantarell in Mexico show sudden production drops, proponents of the "peak oil" theory argue that we will see further declines everywhere in the future.

But for now, supply may actually be building. According to the International Energy Agency, "first-quarter growth of 1.7 million barrels/day was the strongest since early 2005."  And without disruptions in Nigeria and the North Sea, that increase might have been even bigger.

"There is oil available-it's sitting in tankers waiting to be sold," says Fariborz Ghadar, director of the Center for Global Business Studies at Penn State University.

Indeed, according to the Energy Information Administration, US stocks of crude oil have risen steadily over the last six weeks.

"The total amount of supply is about the same as it was six months ago," says Novak. That's when crude changed hands at about $90 a barrel.

Meanwhile US gross domestic product rose by only 0.9% in this year's first quarter. That's not a recession yet, but a soft economy and declining home values have begun to take their toll.

So, too, are soaring gasoline prices-now comfortably above $4 a gallon in some markets and closing in on that dubious benchmark nationwide, according to the American Automobile Association. (Last July, I predicted we would hit $100 oil and $4 gas.)

"The combination of a weaker economy and much higher gasoline prices changes people's perceptions," argues Novak.

And so they do: SUVs are sitting like rotten fruit on dealers' lots, and more people appear to be carpooling, taking the train or bus or even cycling to work.

Again, the numbers tell the story: Newsletter editor Stephen Schork noted that "estimated vehicle miles traveled ... on all US public roads for March 2008 fell 4.3%, or 11 billion, as compared with March 2007 travel."

"This is the first time estimated March travel fell since 1979," he wrote in The Schork Report.

So, not surprisingly, gasoline sales and oil demand in the world's largest energy consumer are tumbling. Oil demand is off 1% so far in 2008, according to the Energy Department-the first time that's happened since 1991, when we were in a real recession.

Add it all up and we're looking at a summer driving season-as critical to energy prices as the Christmas shopping season is to retail-that's dead on arrival.

And although China and India have been powering demand for all kinds of commodities in recent years, there's a limit to everything. The Chinese government continues to keep retail gasoline prices down and pay billions of dollars to Sinopec and PetroChina to subsidize their losses. But several Asian countries have already lifted gas price controls; I wouldn't be surprised to see Beijing do the same once the Olympics are over.

For sure, weaker demand is not what the many oil bulls who've piled into the markets in recent months have been betting on.

There's been lots of debate about what role "speculators" have played in the recent price run-up. But there can be no doubt that as they surged higher, institutional and individual investors jumped in to seek higher returns and protect their portfolios against a faltering US dollar.

The higher crude went, the greater the certitude became that it was heading higher still. Goldman Sachs, which correctly said crude would hit $100 a barrel, upped the ante by forecasting $150 to $200 oil within two years. "Me-too" Morgan Stanley has just predicted $150 oil.

On Thursday, futures contracts on the New York Mercantile Exchange (NYMEX) were calling for light sweet crude to trade above $126 all the way through 2016. 

And last week, the testosterone-charged traders on "Fast Money" agreed to a man that oil was going to the moon.

I don't know about you, but when everybody in the world wants to take one side of a trade, I'd rather be on the other.

How low can prices fall? Novak thinks they could go back to $90, while Ghadar says, "I think we're going to be in a $100 to $150 range for the next two years."

Once world economies and demand recover-and assuming no sudden boosts to supply-crude should resume its upward trajectory. There's just not enough around to satisfy the growing demand of an oil-thirsty globe.

And more immediately, a catastrophic Gulf of Mexico hurricane or a crisis in the Middle East could cause prices to surge.

But right now, the basic economics point to a short-term move in the other direction. If you've just bought an oil ETF, I'd suggest putting in a stop-loss order. This market is going down, baby!
 
Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow or MoneyShow.com.

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