The Crude Fake-Out

Short sellers may be banned in much of the rest of the world, but it appears they're still playing in the oil patch.

Yesterday's meteoric rise in crude prices cooled right back down this morning. Was the $16-a-barrel jump caused by a short squeeze? Fear of failure of the government's financial bailout plan?

Probably the former, analysts say. It works like this: Short sellers bet the price of oil is going down and agree to sell their contracts at a lower price than the market is offering. If oil prices go up, they can face calls for big capital infusions to insure their bets. If they're still on the wrong side of the trade when monthly contracts expire (as they did on Monday, for delivery of October crude), shorts are forced to unwind their bad bets or take physical delivery of the oil. A frantic scramble to get out of those contracts boosts short-term market prices. By the next morning, markets digest the trades and return to more normal levels.

I asked Phil Flynn, Alaron Trading's energy expert, to explain why oil jumped, why it reversed, and where he thinks prices might be headed.

What happened yesterday?
It was obviously a classic squeeze play. I don't know who it was, but somebody had to get out at any price yesterday and was caught short. I don't know if it was somebody who couldn't get product but had to because of the hurricane, or if it was just a big fund that was short. It could've been just one or two players. We'll find out as time goes on. My concern is this gives more impetus to the (theory that) speculators are driving the oil price among people who don't understand how markets work. This is how markets work. People get caught in a position on the last trading day and it drove up the price. It won't have an affect on the consumer.

So are people really trading oil as a safe haven against the falling dollar and the slower U.S. economy?
In last week's trading, we went through three phases. The first was the economy is in trouble, demand will be terrible, and that's why oil was down as much as it was. Then, of course, we got the bailout and people went long on oil, betting demand would be there. Now, we're in the third phase, asking what impact this bailout will have. People went back to oil as a safe haven against the dollar and against systemic risk. Obviously, we know that won't last for a long time. Demand for oil will fall off again if things are that bad.

So barring more hurricanes or other unforeseen events, oil is heading lower?
We won't hit record highs again, barring a hurricane or other problem. We could get back to $120, but we won't get much above that. The biggest critical factors are weather and what happens with the dollar, but we could go back and take out the lows as time goes on.

How low is that, given a stable dollar and no bad storms?
If we take out $90, $67 would be the next target longer term. With all this volatility, it could happen this year, as long as we don't have an early start to the winter or a major hurricane. With supplies as tight as they are, it could be put off to next year. Ultimately, we're going lower.