Oil Prices Fall Nearly $5 in 2 Days

Crude oil prices slipped nearly $2 on weak news coming out of China and a falling stock market Tuesday. Taking this week's losses to nearly $5, the price of oil deflated to just above $68 a barrel on the New York Mercantile Exchange.

The price of crude oil on the NYMEX Tuesday dropped $1.91 to settle at $68.05 a barrel. While intra-day trading briefly took the price of oil up, the commodity could not hold on to the gain due to fears about the Chinese economy and a correction on the equities market.

"There are two things that are overhanging the market," explained Bill O'Grady, the chief markets strategist at St. Louis-based Confluence Investment Management LLC, an investment advisory and management firm. "The first is concerns that China is going to reduce its stimulation of its economy. They have been talking about trying to reduce some of the froth in their economy caused by forced lending; and if they start to do that, that's going to depress commodities in general, and oil goes along with that."

As the third-largest importer of crude oil, increased Chinese consumption has recently been driving the price of oil higher. New fears that the Chinese economy may not be as strong as it had been perceived have helped to push the price of oil down nearly $5 over the last two days.

"Secondly, there's been a positive link between oil and equity prices for the past several months, and today we had a really sharp correction in the stock market, and oil went down with it," O'Grady added. "In fact, when the ISM manufacturing index came out, oil briefly popped positive for the day and was unable to hold the gains because equities were unable to hold the gains."

Seasonal Demand Changes

Also affecting the price of oil, the market is about to officially change seasons. While gasoline inventories are not registering as high as others, the expected change in demand may be tainting investments now.

"The other factor that is going to affect oil is that this weekend formally closes the summer driving season," O'Grady stated. "Once that summer driving demand, which hasn't been frankly all that robust anyway, but once that dries up, we've been worried that oil prices were going to come under some pressure as we move into September just from that factor alone."

While historically demand tends to wane in the autumn, demand for oil may pick up again by the close of the year.

"We'll get a slow drop through fall; the fourth quarter is usually pretty decent for demand globally because you get a lift in heating use," O'Grady said.

Economic Recovery

The underlying supply and demand fundamentals currently cannot support the price, which adds to the market volatility. Oil prices have been bolstered by a belief that the economy is on the mend and that world energy demand will, in turn, increase.

"The global economy is clearly in recovery, and that will also tend to help demand, although to some extent $75 probably reflects that," O'Grady stated.

Over the summer, crude oil has traded in a range between $60 and $75, and the current price of oil is well within that range.

"My hunch is we're going to go retest those lows again, and then we'll see where we go from there," O'Grady predicted. "I wouldn't be at all surprised to see a drop below $60 for a while until we get toward November. Once you get into November, though, I would expect that you would see some seasonal demand for oil lift the market."

While the price of oil has been able to maintain a range, that range is quite large. Historically, the price of oil has not vacillated as much.

"You have an unusually volatile market because you still have some supply constraints on oil," O'Grady said. "The oil that we are finding now in great quantities is expensive to produce and to some extent, if you look at offshore Brazil, we haven't really ever drilled for oil in those kinds of conditions. You have those issues that are out there that tend to support the price."

Yet, the economic recession has negatively affected demand for oil worldwide.

"On the other hand, the global economy is going through the worst recession since at least '73, '74 and maybe since the '30s, and that is going to depress oil," O'Grady added.

Peak Oil

Ultimately, the fundamentals cannot support the current price of oil, but many expect demand to pick up because of supply constraints.

"All this stuff you read about peak oil, that hasn't really changed," O'Grady explained. "If anything, the drop in oil prices has perhaps accelerated that to some extent because it's reduced exploration activity."

Because operators have had to slash exploration budgets in an effort to stay profitable, the number of oil fields being discovered has diminished.

"So when the global economy starts to recover, there's great concern that you will tighten up the market quickly and that's really why oil prices lifted," O'Grady explained. "Based on the current fundamentals it is really difficult to justify oil really above $40, but expectations of future consumption and higher prices have pushed a lot of this price activity forward."

Natural Gas Continues Sliding

The price of natural gas continued falling today on the NYMEX, settling more than 15 cents below Monday's close at $2.821. Plagued by over supply and diminished demand, the price of natural gas has fallen to seven-year lows.

The natural gas market has such high inventories that even an increased demand might not be enough to lift prices. In fact, injections are expected to reach 4 trillion cubic feet.

"We're just kind of choking on the stuff and really to a great extent, you haven't driven prices low enough to finally cause somebody to say, 'I'm shutting in; I just can't do this anymore,'" O'Grady explained. "We're at the stage where everybody knows it needs to be done, and they're desperately waiting for the other guy to do it."

Although onshore rig counts have dwindled, much of the domestic production is ongoing, despite the current low price of natural gas.

"We won't be able to do that indefinitely; and my hunch is if we get a mild winter as the National Weather Service is forecasting, it'll probably happen in February or March," O'Grady said.

"It almost reminds you a little bit of a marginal retailer who is desperately trying to hang on in hopes that the Christmas buying season bails him out," he added. "I think you've got a lot of people in our business who are really trying to stay afloat through the winter and hope that the forecasts are wrong."