Colin Barr

Following the money in banking, economics, and Washington

Oil at the tipping point

April 8, 2011: 6:37 AM ET

Has the great oil rally of 2011 run its course?

Rising oil prices have become a fixture. The IMF declared this week that costly oil is here to stay, after a 12.5% average annual price increase over the past decade. Wall Street is betting the ranch on further increases. With crude hitting $110 a barrel in New York Thursday, up 17% this year, it's not looking like a bad bet.

Peak gasoline?

But for all the talk of global economic growth and unrest in Mideast oil hotspots, there are signs that oil prices are already too high for pinched consumers to bear. U.S. gasoline demand, for instance, dropped 3.7% over the past four weeks -- which energy tracker Stephen Schork calls a "material decline."

Yet U.S. gas prices hit $3.70 this week, their highest level since the summer of 2008. Retail prices are also soaring in the U.K., where the per-gallon price is nearly double the one here thanks to taxes, and in China, where the government is trying to get a hold on commodity prices by pushing down demand.

But rising prices and falling demand can't co-exist for long, which is why some market watchers argue that oil prices are headed for a fall unless new problems emerge -- such as another flareup in the Middle East.

"The market is pricing in a lot of risk and a lot of fear right now," says Richard Soultanian of NUS Consulting in Park Ridge, N.J., which advises companies on energy prices. "What we're looking at right now is really irrational, and unless we get another shock you're going to see the prices come down."

So why are prices so high if demand is tepid? Look no further than Wall Street, where speculative bets on rising oil prices via futures and options amount to the equivalent of 323 million barrels -- four times what Gluskin Sheff economist David Rosenberg calls a normal level.

He says that simply reducing that position by a third, to levels seen last fall around the start of the Federal Reserve's second quantitative easing program, could bring the crude price down to $85 to $90 a barrel.

Schork says $90 oil is entirely plausible, given how little economic fundamentals have changed since the speculative run in oil started at the end of 2010. He attributes much of this year's gains to hedge funds and other traders levering up to bet on commodity prices, which have obliged by surging since Ben Bernanke promised in late August to support the economy with looser money.

The Fed's latest senior credit officer survey reported increased use of leverage by investors such as pension funds and hedge funds.

"The Fed is giving these guys money so they can bet on prices going up," Schork says. "There is probably a $15 or $20 premium in the market because of it."

Soultanian too says a price in the $85-$95 range looks likely once the speculative run ends, for whatever reason. How or when this streak might end isn't clear, obviously, but it's evident that higher oil prices are often short-lived because of the economic slowing they cause.

He likens this year's runup to the one in 2008 that briefly took the oil price to $147.

"We were telling clients then that the forecasts for even higher prices were wrong," says Soultanian, whose firm advises big companies on oil price hedging. "We're telling them the same thing now."

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About This Author
Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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