Investing in oil

There seems to be no limit to how high oil prices can go.

On Thursday, crude oil reached $135 briefly, before settling around $131. Oil has increased dramatically over the few months, and Goldman Sachs analyst Arjun Murti recently advised that crude oil could reach $200 within 6 to 24 months.

According to The Economic Times,

Murti, 38, now a managing director at Goldman Sachs, first came to the fore as far back as 2003-2004 when he predicted that oil prices would breach $80 a barrel when it was still in the 30s. He was sneered at. He was mocked again when he predicted in 2005 that it would double from $50 to $100 before the end of the decade.

Is the rise in oil prices due to fundamental economic reasons, or is it simply a bubble caused by speculators?

Before investing in crude oil, lets review both sides of the argument

Increased volume of oil contracts traded on the NYMEX

There is more and more speculative activity, especially from pension funds and other large institutions.

I just visited www.nymex.com, and it says on its website that the Total Exchange Volume (Not just volume for crude oil) is 1,830,281 for 05/23/2008*

According to Bloomberg,

Electronic volume for Nymex’s crude oil, natural gas, gasoline and other energy products rose 30 percent to 772,567 a day last month

Take a look at the volume for Light, Sweet Crude Oil, taken from NYMEX :

Year	Daily Average	Annual Volume
2008 (April)	536,837	44,557,489
2007	482,246	121,525,967
2006	283,080	71,053,203
2005	237,651	59,650,468
2004	212,382	52,883,220
2003	181,748	45,436,931
2002	182,718	45,679,468
2001	149,028	37,530,568
2000	148,123	36,882,692

In 2006, the daily average volume is 283,080. In 2008, its 536,837, almost a twofold increase.

Surely, the world’s population could not have doubled in 2 years!

What we can clearly tell from this is that more people are trading crude futures, and we can also infer that speculative activity is increasing, which supports the bubble theory. ( An excuse that OPEC uses for not increasing oil supplies)

Nevertheless, the main reason for the increase in oil prices is not due to speculators, but there are other fundamental reasons.

1. Weakening US Dollar
2. Higher drilling costs and national policies that restrict foreign investments
3. Growing demand for oil from rapidly developing countries
4. Supply disruptions (Attacks on oil pipelines in Nigeria)

5. Possible sanctions on oil-exporting Venezuela

As a result, crude oil inventories are down by 5.4 million barrels from last week, according to the EIA.

As long as these supply disruptions are not dealt with, and the US dollar continues to depreciate (It will continue to depreciate in the long run), oil will continue to rally, no matter what speculators do

CONCLUSION

Jeff Rubin, Chief Economist and Chief Strategist at CIBC World Markets sums it up well :

“Even at $133, demand hasn’t been reined in, and without a real raise in supply we think it’s ultimately going to go over $200 a barrel.”

Before investing in crude oil, do remember that short term corrections are possible (perhaps even down to $80), but in the long run, oil prices will shoot up