Oil's Slippery Slope

Oil prices have dropped nearly 30% from their July peak of above $147 per barrel, but what was responsible for the fall? Read my Rant of the Week to find out. I'll explain the economics of oil, how I expect this drama to play out and why it pays to be patient if you're serious about big profits. Plus, check out my latest Wine Find for a vino perfect for the final weeks of summer.

Toby

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Read on to find out more about Toby's weekly investment newsletter, ChangeWave Investing.

Is the Oil Bull Market Over?

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.

How the Oil Drama Will Play Out

Now let's turn to the fundamentals. When it comes to oil, supply has overtaken demand in the slowing world economy.

According to the most-recent Reuters survey, OPEC is pumping almost 800,000 barrels per day (bpd) more than its target, and output in August rebounded to 4.05 million bpd from 3.7 million bpd in July, due to higher sales.

At the same time, oil consumption is down more than 1 million barrels a day in the United States, Europe and Japan.

The price of oil is now in OPEC's hands -- they are the "marginal supplier" of the world's 85-million-barrel-a-day oil habit.

And OPEC knows better than anyone else that $140 oil kills long-term demand and makes alternative energy economics soar. (However, thanks to more state mandates, impending carbon caps and two green-thinking presidential candidates, falling oil prices are not going to squash the long-term demand for alternative energy.)

OPEC also knows that the cost of a new non-OPEC barrel of oil is about $50-$65 or higher, because the majority of newly found oil is coming from offshore deepwater drilling.

So, what should you expect?

1. Oil to fall below $100 per barrel and gain support from OPEC at its Sept. 9 meeting.

2. Weaker demand from the recessionary economies of the world (the United States, Europe, Japan and much of the rest of Asia) should bring oil down to the $85-per-barrel level.

3. If the price of oil stays down, the most-expensive oil fields -- namely offshore deepwater rigs -- will be shut down.

Patience is a Very Profitable Virtue

At ChangeWave Investing, we are waiting patiently for this pullback in oil prices because it will cause our favorite oil exploration and production (E&P) companies to come down in valuation and offer us great entry points.

In particular, we are looking for oil shale plays that are what I call 20/20 companies -- those that are growing their reserves 20% or more, while at the same time growing their production 20% or more.

If you are patient and let these stocks come back to you, then you'll get great entry points in the very best natural gas and oil E&P plays. (Get the list of the stocks you'll want to own.)

My advice is to keep your powder dry and let the oil drama play out. You don't want to chase these stocks. Remember, a great stock at the wrong price is still a bad investment.

Toby

P.S. To see our list of the best oil and gas exploration and production plays, sign up for a 90-day, risk-free trial subscription to ChangeWave Investing. But don't wait. This is a volatile market, and you want to be ready to jump in when these names pull back. Get your hands on that list today.

Discover the Way to Beat Inflation

Consumers are feeling pain at the gas pumps and in the grocery store line.

Inflation is rising and your wealth is slipping through your fingers unless your investments are capturing 8% yields or more. Sadly, most investors are only reaping 2%-3%.

Stop losing ground. Learn how to come out of this recession wealthier than you were when it began.

Watch 'Bulls & Bears' on Fox News

Be sure to tune in to Fox News Channel this weekend and join Toby and the crew on "Bulls & Bears" for their weekly market roundtable as they kick off the Fox News Channel business block on Saturday, Sept. 6, at 10 a.m. Eastern. ("Bulls & Bears" replays at 4 p.m. Eastern, Sunday, Sept. 7, and 4 a.m. Eastern, Monday, Sept. 8.) Or you can catch the show Saturday evenings at 6 p.m. Eastern on the Fox Business Network.

Check your local cable listings or satellite guide to find the Fox News Channel location and times for your area. NOTE: These shows are NOT on your local Fox network station. They are on Fox News Channel on your cable or satellite system (Channel 360 on DirecTV, Channel 205 on Dish Network). Keep in mind that these schedules are subject to change, and the Fox News Channel business block and other programming may be pre-empted for breaking news events.

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Wine Find: A Zesty Sicilian

Bid farewell to summer with a tangy white like the 2007 Inzolia Caleo. This rich wine is spicy on the nose with notes of pear, apple and tropical fruit on the palate.

The Inzolia grapes for this vintage, also known as Insolia or Ansonica grapes, are grown in Sicily and were harvested mid-September to deliver a full, ripe taste. Pick up a bottle for less than $15. Try it with seafood -- it's molto bene!

To share your favorite wine or food experience, e-mail me through the form at: www.changewave.com.