You have probably noticed the increased cost of gasoline in recent weeks. I drive a diesel pickup, and the cost of diesel fuel here in central Utah is running about $3.60 a gallon–as much as 80 cents a gallon more than regular gasoline. When it comes to higher fuel prices most Americans have no options other than to grimace and fork over the money.  Mass transit, carpools, or even just driving less are not legitimate alternatives for many.

While most people know the price of oil not many can explain why, including experts. The increased cost is not related to a decline or disruption in supplies, which are holding steady. The higher cost is also not explained by increased demand or to rising political tensions in oil-producing areas.

Instead, some oil industry experts blame the current price increase on speculators.

For example, In an article in the Ft. Worth Star Telegram, Fadel Gheit, an energy analyst for Oppenheimer & Co. in New York is quoted as saying he is convinced based on supply and demand the current price of crude oil should be no more than $55 a barrel–about $40 lower than current levels.

Gheit was quoted as saying that commodities trading in oil is the world’s largest unregulated gambling hall. “This is like a highway with no cops and no speed limit, and everybody’s going 120 miles per hour.”

Trading oil futures gives speculators tremendous leverage. Each contract generally controls 1,000 barrels of crude oil and contracts can be purchased on margin, meaning the investor does not have to put up all the money. Margins can be as low as 5% of the contract value.

The impact of this speculation can be seen on the chart below. The black line is iPath Crude Oil Exchange Traded Note (OIL). Notice that over the past 10 weeks, OIL has risen about 40%. The blue line is Oil Services HOLDRS (OIH). The difference between these two vehicles is that the OIL reflects the price of crude oil while OIH is reflective of the oil services industry. Over the same period, OIH has risen just 20% and has really gone sideways for the past six weeks while OIL continued to rise. That means in spite of rising oil prices, oil companies and other oil-related businesses are seeing declining profits.

The gold line is the S&P 500 and is included just for comparison purposes. Notice that it has risen about 8% since mid-August.

Like most speculative investments, this run-up in oil prices carries a high degree of risk. Those who are bidding the price up are betting that something is going to increase the demand for oil or decrease the supply. That could be an escalation of the war in the Middle East to include Iran. It could just be a seasonally higher demand because of cold weather. Eventually a day of reckoning will come and if those or other events have not happened, those speculating on higher prices will be forced to sell their positions at a loss and we will see the price of oil start to come down.

In the meantime, everyone who has to use oil or gas is going to be paying higher prices. Since that means virtually every consumer and supplier in the country, that will increase inflationary pressures on the economy. Under normal circumstances, when inflation becomes a threat the Federal Reserve increases interest rates and tightens the money supply. Wednesday the Fed did exactly the opposite and lowered rates. Here is how the Fed explained this apparent contradiction in the release announcing the rate cut:

“Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.  However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

“Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. 

“The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.”

The combined effect of these factors is that investors are starting to get nervous about the economy–not the economy today, but the economy in the near future. Remember that consumer spending accounts for two-thirds of U.S. economic activity. From now until the end of the year is the most important time for consumer spending because of the Christmas holiday season. If consumers are spending more money on gas, heating oil, milk, eggs, and other essential items, that means they will spend less on other things. That is why we saw a sharp sell off today and why it is likely that in coming weeks, the down days are probably going to be volatile and more frequent.

That doesn’t mean investors need to be in a panic mode. After all, this is traditionally one of the strongest periods for stocks and so far the market’s uptrend is still intact. However, given the combination of a weak housing market, record high oil prices and rising inflation, investors need to watch market activity closely and be prepared to react quickly if an emotion-driven sell-off ensues.

F.S.