Oil’s rally was a major topic in the financial media on Tuesday and Wednesday, and I listened to a long list of pundits attempt to explain the recent rally in crude prices. Many analysts asserted that oil’s run-up has little to do with fundamentals of supply and demand. By far the most popular rationale attributed the rally in oil to traders betting against the US dollar.

There’s an elegant simplicity to this logic: Crude is priced primarily in US dollars; a weakening dollar can push up the dollar price of crude oil.  But, the chart below complicates this pat explanation.

Source: Bloomberg

This chart shows the price of WTI crude oil in euros–rather than dollars– from the beginning of 2009.

If the rally in oil were simply the result of a weakening dollar, one would expect this chart to show a relatively flat line. In other words, oil prices would trend higher in dollar terms but, thanks to a strengthening euro, would remain relatively constant when priced in the latter currency.

But that’s clearly not what the chart shows. Crude oil prices traded as low as EUR26.50 this year and are now trading near EUR50; priced in euros, crude oil has nearly doubled in value. Interestingly, oil’s rally has accelerated in recent weeks, even as the European currency has strengthened against the greenback.

For millennia, gold has been considered a unit of value and the closest thing to a universal currency. Although few consumers use gold coins to pay for goods and services directly, most investors regard gold as the ultimate hedge against a weak dollar, rising inflationary pressures and financial turmoil.
The chart below shows the price of oil divided by the price of gold. In other words, this is a measure of how many ounces of gold are needed to purchase a barrel of WTI crude oil.

Source: Bloomberg

With gold currently selling for about $955/oz, about 0.073 ounces of the precious metal buys a barrel of oil. However, in early February the same barrel of oil commanded about 0.035 ounces of gold; the price of a barrel of oil has more than doubled in gold terms.

The implication of these charts is clear: A weakening dollar may contribute to rising crude prices, but this trend is neither the sole cause of rising oil prices nor the primary driver of expensive oil. If traders were simply betting on a falling dollar, oil prices should not be doubling in price in both euro and gold terms.

Speculation is another common explanation for the upturn in oil prices, a rationale that was even more popular last summer when oil prices spiked to nearly $150/bbl. For that matter, speculators have been a common scapegoat for politicians for centuries.

The first point to remember is that speculators aren’t evil. Traders who buy and sell crude oil futures contracts provide significant liquidity to the market; this makes it easier for firms using futures to hedge their oil exposure to get a fair price. And speculators typically buy or sell crude based on their assessment of market conditions; just as with stocks or any other traded market, oil speculators cannot fight fundamental conditions forever. Ultimately, the real forces of supply and demand will win out.

Leaving aside these theoretical considerations for now, we can assess the impact of speculation on crude prices directly by watching the Commodity Futures Trading Commission’s (CFTC) weekly Commitment of Traders (COT) report. The COT divides traders into two main camps, commercial and non-commercial, and details their long and short positions.

Commercial traders are typically firms involved in the energy business. That list would include oil producers that use futures to lock in prices for the commodity they produce. The commercial category could also include big consumers of oil that use these markets to hedge their potential exposure to rising fuel costs.

Non-commercial traders are usually what most would consider speculators: individuals and institutions betting on crude oil prices rising or falling via long and short positions. Check out my chart below for a look at the net position of crude oil non-commercial traders on the New York Mercantile Exchange (NYMEX).

Source: Bloomberg

This chart shows the total number of long futures and options commitments held by non-commercials minus the total number of short positions. Positive numbers indicate that non-commercials are net long oil; negative numbers indicate that traders are net short.

Based on this data, crude oil speculators are long about 109,000 crude oil contracts. Although that’s up from 70,000 contracts in early May, it’s still considerably less than the net long position held at the beginning of 2009.

Last summer, some were alleging that commodity index funds–basically funds designed to profit from rising commodity prices–were being classified by the CFTC as commercial traders even though they were really just speculators. But, if that were the case, the argument that speculators are driving oil prices falls even flatter: Commercial traders are currently net short crude oil.

And one more point is worth noting: each NYMEX futures contract covers 1,000 barrels of crude oil–a net long position of 109,000 contracts would cover 109 million barrels of oil. That seems like a rather large amount until you consider that the world consumes 85 million barrels per day; the total net long position held by speculators on NYMEX totals about 1.3 days worth of supply.

 Neither irrational speculation in oil markets nor a weaker dollar satisfactorily explains the jump in crude oil prices. In my view, shifting expectations for supply and demand are driving oil’s recent move.

When you hear a commentator state that oil fundamentals are bearish, there’s a good chance he or she is talking about US oil inventory statistics. Released weekly by the EIA, the oil inventory report tells us exactly how much crude oil, gasoline and distillate oil is being held in storage in the US. High inventory levels are bearish because they imply a glut of oil supply.

Amid a weak economy last year US demand for oil plummeted, and inventories of stored crude have built to record levels this year. This problem wasn’t exclusive to the US; oil demand across the developed world has collapsed, and crude stockpiles have surged.

Still, the picture is improving. US gasoline inventories have fallen sharply in recent weeks just as the peak of the Northern Hemisphere summer driving season kicks off. In fact, US gasoline inventories are actually setting new five-year lows for this time of year.

Oil inventories remain bloated, but this chart provides a clearer picture.

Source: Bloomberg

This chart compares US crude oil inventories to analysts’ consensus expectations over the past year. Big positive numbers suggests bearish surprises: On these weeks, inventories fell less than expected or grew more than expected. On the other hand, negative numbers are bullish for crude, denoting inventory numbers that are tighter than consensus expectations.

This chart indicates that recent reports released by the EIA have been bullish for crude, showing surprisingly large declines in inventories. While there’s still a glut of oil in storage, that glut is shrinking.

More important, if we step back from weekly inventory figures, the longer-term picture appears even more bullish. As I noted in this e-zine as well as in the May 22, 2009 issue of Personal Finance Weekly entitled “Leading out of Recession,” the US economy appears to be stabilizing and emerging market economies are recovering at a far faster pace than most expected at the beginning of 2009. An improving global economy will lead to a re-acceleration of oil demand in coming months.

And don’t forget the supply side of the equation. Far too many pundits assume there’s sufficient producible oil to meet rising demand. I’m not a strict “peak oil” adherent, but I believe the world is closer to peak production than many assume and suspect that global oil production can rise further from current levels. That said, production can’t rise with oil at USD50 per barrel; prices above the USD70 to USD80 level are required to incentivize new exploration and development.

As we’ve seen over the past year, global oil exploration and drilling activity declines rapidly once commodity prices sink below the USD70. In some markets such as Russia, drilling activity has collapsed.

Given the decline in investment, it’s likely that just as global oil demand revives in 2009 and picks up steam in 2010, non-OPEC oil production will fall. This sets us up for a supply crunch that I believe will bring us back to $100/bbl oil by early next year.