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Why Did Oil Jump $10 This Week?

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If you have been reading this commentary for the last several months you know the answer to my question. Despite what you heard in the media the decline in crude prices was not due to a decline in demand.

The decline in crude prices was due to the forced liquidation by hedge funds, mutual funds, institutions, primary market makers and hedgers. Oil had been such a popular investment for so long that nearly every investment portfolio had an energy component. Everybody knew the spike was overdone and everybody trading for a living had shorted that spike once it rolled over. I reported to you last week that open interest in put contracts on crude futures was 128,000 contracts and call options only amounted to 4,000 contracts. This was a monster short squeeze waiting to happen.

Just as the spike became overdone as the media pumped the reasoning behind the gains and prompted everyone with a spare buck to chase the price to $147, the media's constant forecast for $50, $40 or even $30 a barrel oil again accelerated the decline. As long-term positions began to hit their stops the selling increased. As the price fell the banks and brokerages raised the margin requirements on crude contracts and that increased the urgency to exit. As the credit crisis deepened and broadened to other currencies the various carry trades became rapidly unwound. Borrowing yen at less than 1% interest to buy dollar denominated commodities suddenly turned ugly when the dollar/yen relationship was suddenly thrown out of kilter by the credit crisis. Every day the dollar strengthened the urgency to dump the carry trade grew at a frantic pace. With the dollar going up and the price of oil going down fund were losing money at a hectic pace. Hedge funds borrow 4-8 times the money they have on deposit so a $10 billion fund has an average of $50 billion in positions. Those loans were called over the last couple months as banks tried to raise capital by reducing lending. This was effectively a margin call on the hedge fund industry and we saw the results in the sharp drop in all commodities not just oil.

I saw several news reports Wednesday night saying the rate cut by the Fed and expected cuts overseas will stimulate demand and that is why oil rallied so strongly. Give me a break! Do you honestly think that anyone reading this commentary is going to rush out and fill up their tank next week, next month or even next quarter because the Fed lowered the interest rate by 50 basis points? Maybe over the very long term as the economy begins to recover with the aid of the rate cuts but definitely not this year.

It was a short squeeze stupid! I want to yell at the TV commentator every time I hear their stupid reasons how demand expectations drove the price higher. This is just the pendulum swinging back the other way and relieving some of the oversold conditions I reported above. Mutual funds accounting for 75% of all fund investments have their year-end on Friday. Oil was a bad investment over the last three months so funds dumped any remaining oil positions heading into this week in an effort not to look stupid to investors when they get those year-end statements. With only two days left in their fiscal year it was time to window dress those portfolios and that is why the market rallied over the last two days. Funds that were not in oil probably thought it was a good time to buy at $61 and the short squeeze began. When open interest is 30:1 in favor of puts it does not take a market wizard to see the potential for an explosion higher.

Crude prices have risen from $61.30 on Monday to trade over $70.50 on Thursday morning. Is a ten-dollar move too much? Absolutely but short squeezes take on a life of their own and seldom slow until the pressure is equalized. I expect continued volatility as we get the Q3 GDP on Thursday and the ISM on Monday. Both are expected to drop sharply and that will give the media another chance to preach falling demand for oil and other commodities. On Nov-12th the IEA is scheduled to release their 2008 World Oil Report and rumor has it the report will show we are not as oversupplied as everyone thought over the next few years. I definitely want to be long oil and oil stocks over that report release but I am not buying a $10 spike tomorrow. I would look to buy dips back to $65.

Jim Brown

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