Is the Oil Market Reinflating?

I have been amazed to watch the price of oil crash from its peak of $147 to its recent low of $62.  If you read my prior article, you know that I believed that there were strong fundamental reasons that were driving the price of oil higher.  After oil prices collapsed 57% from their peak the main reason given as an explanation for its fall was the decline of oil consumption as the economy began to slow.  While this theory certainly holds true to some degree, I believe the driving factor in oil's decline has been the lack of liquidity in the marketplace rather than the declining consumption of U.S. businesses and consumers.

In the last six months, there have two major events that have impacted petroleum pricing.  These two events were the bankruptcies of Semgroup and Lehman Brothers.  As you can see from my chart Semgroup announced its bankruptcy on July 22, 2008.  This was only a week after oil prices peaked.  A few days before it declared bankruptcy Semgroup had a conference call with its creditors informing them of its problems.  As knowledge of Semgroup's problems spread, anyone doing business with Semgroup took steps to cease any relationship with what was one of the nations largest energy marketers and traders.  This counterparty risk created a bottleneck between energy producers and energy purchasers that prevented oil supply from reaching its end markets.

On September 15, 2008, we had our second major event, the bankruptcy of Lehman Brothers.  This bankruptcy seemingly came out of nowhere because everybody had expected the Treasury to step in and broker a purchase of Lehman Brothers as it had done with Bear Stearns.  Instead, the Treasury balked and allowed one of the nation's largest investment banks to fail.  As a result, oil tanked the next day before rallying.  Everything seemed fine for a couple of weeks as nobody could quite grasp the impact this would have on the US economy.  Then a couple weeks later the flow of credit stopped as fear of insolvency had crippled the ability of almost every financial institution to function normally.  Like all markets, the energy markets depend on credit to function, as most companies need credit to purchase oil inventories.  With the credit crunch in full swing, many players began to have problems obtaining financing.  This created yet another bottleneck in the nation's energy markets.

The ability of speculators and corporate entities to trade and own oil contracts was impacted by both of these events.  It is clear that if speculators are forced to liquidate long positions then oil prices are going to drop and the same can be said for corporate entities.  While the liquidity issue has become a major problem for the energy market the counterparty risk issue has also developed.  With the Semgroup and Lehman Brothers bankruptcies, anyone owning contracts that Semgroup or Lehman Brothers were counterparties to was in trouble as they were more likely then not no longer safely hedged. 

The first round of capital injections in the US banking system, while saving our nations banks will likely save the commodity market.  The bailout should eliminate the problems that are preventing the normal functions of the oil market, whose disruption was caused primarily by the bankruptcy of both Semgroup and Lehman Brothers.  So far, the behavior of the price of oil seems to be confirming this as the price of oil has rallied strongly from $63 on Monday.  Looking back, it is clear that the capital injection is also the most logical explanation for not only the rise of the stock market but the commodities as well. 

Disclosure: None