Marketplace Scratch Pad

Oil is irrational

Scott Jagow Jul 6, 2009

The price of oil fell about 3 bucks today to $64 a barrel. Oil started the year in the $30 range. It’s been above $70 lately. Last year, you’ll remember, it hit $146 a barrel. Oil has rarely been this volatile, and it’s not good for the economy.

At this point in the recession, low oil prices would seem to make sense because the worldwide demand just isn’t there. But we have to keep in mind that oil prices are influenced, at least in part, by a cartel whose mission is to set prices. From the New York Times:

The OPEC cartel has also been remarkably successful in reining in production in recent months to keep prices from falling. Even as prices recovered, members of the Organization of the Petroleum Exporting Countries have been unwilling to open their taps.

The International Energy Agency held out the prospect that energy demand was unlikely to recover before 2014. Yet the indicators that would traditionally signal lower prices — like high oil inventories or OPEC’s large spare production capacity — do not seem to hold much weight today, analysts said.

“Crude oil prices appear to have been divorced from the underlying fundamentals of weak demand, ample supply and high inventories,” Deutsche Bank analysts said in a recent report.

And that has people asking (just like they did last year) — are speculators driving the price of oil? It’s a ridiculous question. We’re talking about a commodities market. Of course people are speculating.

But most companies don’t really care who is bidding on oil. They just hate the volatility because it makes it much more difficult to plan for the future:

To call this extreme volatility might be an understatement,” said Laura Wright, the chief financial officer at Southwest Airlines, a company that has sought to insure itself against volatile prices by buying long-term oil contracts. “Over the past 15 to 18 months, this has been unprecedented. I don’t think it can be easily rationalized.”

The experience of the past year, she said, “has convinced us we cannot afford to not be hedged.”

For a while, Southwest was one of the few profitable airlines because it paid for fuel ahead of time at set prices — it was immune to soaring price of oil. But when its hedges ran out, Southwest got killed. Then it re-hedged and prices fell dramatically, so it got killed the other way — it was paying much more for oil than everyone else.

This lesson also applies to you and me. Just as volatile oil makes it hard for companies to plan, it makes it difficult for households to predict how much money to set aside for buying gas. The strategy I’ve been employing lately is — drive as little as possible.

Like they always say … you can’t time the market.

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