Is the Oil Bull Market Over?

By Tobin Smith

It's clear that the fear of Hurricane Gustav turning into another Katrina supported higher oil and natural gas prices against a backdrop of weakening demand.

So, where are those rotten speculators Nancy Pelosi wants to regulate? Could it be that the Congress members with a vendetta for greedy speculators are getting a lesson in how free markets really work?

But I digress.

It now appears the market is finally facing up to the realities surrounding it. Or is it?

Let's go to the scoreboard.

For starters, we're seeing a strong rebound in the U.S. dollar. When we returned from Labor Day weekend, we saw the euro fall below $1.45 against the greenback. That's almost a 10% move down from its record high at around $1.60 in July.

And oil prices have dropped almost 30% from their July peak just above $147 per barrel.

But, if oil prices had been driven solely by the weak dollar, how is it that they have fallen so far? Isn't oil supposed to be the new dollar?

Well, boys and girls, anyone who told you that the bubble in the oil markets was simply an anti-dollar play should apologize.

If you're a euro-watcher like me who has been forecasting weak growth in Europe, it should come as no surprise that its central bank was throwing its economy under the bus in the name of inflation protection. Most of Europe is in recession and needs help from its central bank or its nations will suffer greatly.

And I have more news for you: In the first six months of 2008, the United States was the strongest G8 economy, and that's why the dollar is rebounding.

The Real Reason Oil Prices Spiked

Clearly, the super-spike in oil prices was not solely a dollar issue -- otherwise the dollar would be down around 30% against the euro.

So, what was the main cause?

The No. 1 culprit was the melt-up in oil futures prices thanks to massive short-covering by hedge funds and oil traders. Short-selling hedge funds and oil traders lost at least $20 billion in just a few weeks.

Never forget this reality of oil trading: The oil futures market is very small compared to stocks, bonds or currencies.

It may have seemed bizarre to see a spike in oil as fundamentals were weakening, but the reality is it wasn't strange at all. It was a case of short sellers all rushing for a very tiny door. And the gatekeepers -- in this case the people who owned June $110 futures contracts -- were simply doing what they should have been doing, i.e., killing the shorts.

Counter-fundamental moves like this come from trading issues -- i.e., supply and demand issues for oil futures contracts. In other words, there was an extreme shortage of June $110 futures contracts, not oil itself.