Don't Fall For It

Like any commodity subject to the forces of supply and demand, oil prices go up and down, but as the graph on the left shows, 2008 was as especially volatile year. Oil prices reached the highest in history at more than $147 per barrel in July (resulting in $4/gal gas prices), then plummeted to under $37 per barrel last month (it's now at $34). Historically, volatility is a sign of an unstable market whose direction is uncertain. 

So what happened?

One of the main reasons why the price of oil has dropped through the floor is because, in the past four months, demand has reduced due to the global recession. But that doesn't fully explain the volatility in the market. A recent article in BusinessWeek and a report by 60 Minutes suggest a reason why oil/gas prices are swinging as much as they have been: speculation. 60 Minutes explains:

To understand what happened to the price of oil, you first have to understand the way it's traded. For years it has been bought and sold on something called the commodities futures market. At the New York Mercantile Exchange, it's traded alongside cotton and coffee, copper and steel by brokers who buy and sell contracts to deliver those goods at a certain price at some date in the future. 

It was created so that farmers could gauge what their unharvested crops would be worth months in advance, so that factories could lock in the best price for raw materials, and airlines could manage their fuel costs. But more than a year ago those markets started to behave erratically. And when oil doubled to more than $147 a barrel, no one was more suspicious than Dan Gilligan. As the president of the Petroleum Marketers Association, he represents more than 8,000 retail and wholesale suppliers, everyone from home heating oil companies to gas station owners. 

When 60 Minutes talked to him last summer, his members were getting blamed for gouging the public, even though their costs had also gone through the roof. He told Kroft the problem was in the commodities markets, which had been invaded by a new breed of investor. 

"Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that are looking to make money from their speculative positions," Gilligan explained. Gilligan said these investors don't actually take delivery of the oil. "All they do is buy the paper, and hope that they can sell it for more than they paid for it. Before they have to take delivery." 

"They're trying to make money on the market for oil?" Kroft asked. 

"Absolutely," Gilligan replied. "On the volatility that exists in the market. They make it going up and down." 

In other words, the oil market is like a casino with people betting that the future price will go up or down. The thing is they don't care if the price goes up and down. They can make money either way. 

Considering the economic crisis, most consider low gas prices a welcome respite. However, I wouldn't expect gas prices to stay this low for long. Unfortunately, people are already starting to buy SUVs and trucks again. They'll be kicking themselves when they have to shell out $100 to fill their tanks.