John Licata, The Street
The 35% drop in oil prices this fall has been breathtaking. No one — not even energy experts — expected prices to fall this far, this quickly. And the slide doesn’t seem to be over.
What happened? True, the U.S. has nearly doubled its oil production over the past five years, while OPEC and other suppliers have been unwilling to cut back on production. Demand has also been softening. But that still doesn’t explain why prices suddenly fell off a cliff.
The answer seems to have less to do with supply and demand and more to do with how oil is traded. In short, the slide in oil prices appears to be mainly investor-related, not based on fundamentals. For that reason, oil prices could rebound just as quickly and violently as they fell.
Here’s what may have happened. As oil prices began falling this summer, an increased number of traders and other big investors appears to have bet that prices would bottom, especially in October as evidenced by record energy options contracts traded on the CME, the large options and futures exchange. When that didn’t happen — in part because of the strengthening dollar — these investors found themselves on the wrong side of a very dangerous trade.
Exposed to even bigger losses, they had to get out quickly. It’s what is known in investing as trying to catch a falling knife. This rush to the exits only exaggerated the selloff in oil prices, which quickly spread to energy stocks such as ConocoPhillips (COP) and BP (BP) and other related investments. We are still feeling the fallout.
When will the carnage end? No one knows. But there are plenty of reasons why fundamentals may return soon and oil could start climbing again.
For starters, 70% of all crude oil is used for transportation. Despite the viability of Tesla (TSLA) and the electric car, that industry is not yet challenging combustion engine vehicles as many had hoped. So Americans are likely to keep driving gas-guzzling cars, which will help oil prices find support.