Oil and Asset Classes

An article in yesterday's Financial Times raised some provocative questions about the future status of commodities as an attractive asset class for institutions and other investors seeking to diversify their risks and improve their returns. Anyone who believes that the extraordinarily high oil prices we experienced this summer were influenced by commodity speculation should regard the response of portfolio managers to this proposition as quite significant for the future path of oil prices, which have recently plummeted in line with other assets. And because that drop has been overshadowed by a global stock market crash, we haven't had a chance to work out all its implications, other than its short-term benefits for consumers.

As of this morning's session, oil prices were down nearly 45% from their peak of $145 per barrel in July. The largest part of that decline is attributable to the dramatic reversal of long-term demand trends in the US and EU, and a slowing of demand growth in developing Asia. However, non-fundamental factors have also played a role: Liquidations by hedge funds and other institutions needing to cover redemptions and margin calls, along with a healthy dollop of fear and flight to safety, helped drive oil to a $77.70/bbl close last Friday, the lowest since September 2007. This is almost certainly an over-correction, and the steep "contango" in the market reflects that likelihood, with prices for delivery in 2010 and beyond in the mid-to-high $80s. Those are still dramatically less than just a few months ago.

What does all this mean for the price of oil in the years ahead? That question ought to be of great interest to struggling automakers, among others. If you are scrambling to build highly-efficient cars in response to the $4 per gallon pump prices that effectively ended the SUV fad, falling prices are a big potential problem. Gas prices starting with a "2" are popping up in some markets, and if current oil prices and refining margins hold, they should be ubiquitous in November, with the possible exception of California. Could that prompt another shift in car-buying patterns, slowing demand for smaller, thriftier cars, and for alternative fuel or flexible fuel vehicles?

At the same time, the $700 billion oil wealth transfer statistic cited by T. Boone Pickens and endlessly repeated by politicians and pundits now looks wildly off: At current prices, the tab for net US oil and petroleum imports in 2009 could end up below $350 billion. That's still a huge amount of money, but it cuts by half the payoff available from drastic changes in our energy economy.

Future oil prices will be determined mainly by the fundamentals of supply and demand, including the durability of demand growth in Asia and the Middle East and OPEC's discipline in cutting output and making the cuts stick. Although commodity index investors could amplify the resulting price changes, as they probably did earlier this year, their impact is likely to be on a smaller scale. A rebounding dollar reduces the potential rewards, while global de-leveraging dries up the fuel for such investments. I'm just not sure where oil prices go from here--lower or much higher, again. But unless the deficits from massive government financial interventions trigger a new wave of inflation, making oil and other commodities look more attractive to a much broader array of investors, the controversy over oil-price speculation that raged for much of this year is starting to look like another casualty of the financial crisis.