The End of Oil's Boom?

Have oil prices seen their upper limit? That's the question traders and analysts are debating following a two-session, 7% drop for crude oil. West Texas Intermediate settled at $134.58 a barrel on the New York Mercantile Exchange on July 16, marking a decline of $10.65 per barrel over two days. Oil prices have tumbled nearly 10% since hitting a record trading high of $147.27 on July 11.

Analysts say the two-day sell-off reflects the market's recognition of reduced demand in the U.S., even if longer-term trends remain bullish. Oil traders, it seems, may have finally noticed the public's reaction to high energy prices. "For a while the market heightened all bullish news and discounted anything bearish," says Joel Fingerman, president of FundamentalAnalytics.com, a Chicago-based energy consulting firm. "But people are giving up their Humvees and pickup trucks, and the market is starting to care."

"Astonishing" drop in demand

Analysts say that while oil traders have been betting on surging demand from developing countries such as India and China, reduced demand in the U.S. is now sending bearish signals the markets can't ignore. Moreover, Energy Dept. data released July 16 showed a 3 million barrel jump in U.S. crude inventories, to 296.9 million barrels; analysts had expected a decline. Moreover, U.S. demand for energy products has fallen 2% from the same period last summer, according to a four-week average federal regulators release weekly. "I think this is a precursor to a much bigger sell-off," says Peter Beutel, president of Cameron Hanover, an energy risk-management firm in New Canaan, Conn. "It's very possible we have seen the worst this [price surge] is going to do to us. The tide is starting to change."

Fingerman points to the 5% drop in U.S. gasoline demand from the same time a year ago as evidence of a "structural shift in the car economy." He points to the sharp sales declines for large vehicles at General Motors (GM) and Ford (F), as well as wider use of public transport.

Since the U.S. consumes a quarter of the world's gasoline on a daily basis, lower U.S. demand has a "huge ripple effect" on the market, and that is starting to be reflected in prices, says Fingerman, who considers $80 oil possible by year's end. "I think it's the beginning of the end," he says. "The fundamental data just keeps getting more and more bearish." Another oil contrarian, Lehman Brothers (LEH) energy economist Edward L. Morse, sees oil in the lower $90 range by 2009. "The drop in demand (BusinessWeek, 7/16/08) has been astonishing, particularly in the U.S.," Morse says.

The Drive for More Regulation

Other analysts say that while oil investors have been benefiting from high prices, consumers will eventually see relief. "The function of the price mechanism is not to enrich speculators or make Goldman Sachs (GS) rich beyond imagination," Cameron Hanover's Beutel says. "The high price is supposed to hurt demand and encourage new supply. The price mechanism is finally starting to work."

The notion that speculation in commodities markets has caused oil's sharp rise has drawn some adherents in Washington. A series of congressional hearings has addressed the issue and more than a dozen bills have been proposed to further regulate commodities trading.

Consumers are increasingly seeing the oil markets as the source of sharp price rises. In a poll released July 16 by multi-industry coalition Stop Oil Speculation Now, 80% of 800 Americans polled said they believe oil commodities speculators are manipulating the price of oil, with more than two-thirds favoring more regulations on oil trading.

The harder they fall?

A range of trading groups—hedge funds, investment banks, commodities exchanges, and institutional investors—argue that prices have risen not because of increased speculation but because of supply and demand. That view is shared by commodity analysts at big firms such as Goldman Sachs and Morgan Stanley (MS) who predict oil prices will continue to rise. They say global development is driving demand, which is outstripping supply.

In a July 14 letter to Congress, the International Swaps & Derivatives Assn., a group hoping to derail any push for more regulation (BusinessWeek.com, 7/13/08), also cited tight supply and demand: "The most important fact in the debate over higher oil prices can be summed up in one statistic from the International Energy Agency: In 2007 global demand for oil was 86 million barrels a day; the global supply of oil that year was 85.5 million barrels."

It's unclear whether Congress will actually pass legislation for stricter market oversight. But some analysts insist that regardless of what the government does, high prices aren't here to stay. "Oil prices are inflated and are not supported by market fundamentals, and the longer they remain high the sharper the decline will be," says Fadel Gheit, senior oil analyst for Oppenheimer (OPY).

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