Oil's Hidden Message


Oil prices fell another 2.3 percent to below $39 a barrel on Tuesday as a raft of gloomy economic data reinforced expectations that world energy demand will shrink for the first time in 25 years.

Robust demand from emerging markets such as China had pushed oil prices to their peak above $147 a barrel in July. Now even the dynamic Asian economies appear to be suffering.

“I don’t think the global consumer could handle the dramatic rise in energy prices that we saw in June and July. It was too far too fast,” says Joe Terranova on CNBC’s Closing Bell.

However, Terranova believes that long-term oil is heading higher. He can't imagine any other scenario as emerging markets resume their plans to put up new buildings, improve roads, and generally advance their standard of living.

But timing is everything.

"People are sitting on cash -- big lumps of it," adds Mark Mathias, chief executive of commodity fund manager Quantum Asset Management. "Everyone is worried about when to go back in. Long-term, oil is cheap, but who knows where it goes in the short term."

The Heart Of the Issue

The deep discount of near month oil futures contracts against later months is scaring investors, adds Erik Simpson, managing director at Vantage Energy Hedge Fund.

Traders found big profits during much of oil's rally by selling front month futures contracts and buying cheaper second-month contracts -- something possible only in a market structure called backwardation.

But that's not the case anymore. As demand has collapsed, inventories in developed economies have begun to build, adding further downward pressure on prices especially for front-month futures.

"There is a glut in the front end of the markets, we're basically out of storage in the United States," said Simpson. Not until those market influences change can oil climb higher.

So, what is the steep decline in oil trying to tell us?

“Oil is predicting an economic environment that is significantly challenged and an investment community that is not yet ready to take risk,” Terranova concludes.

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