Why oil prices are dropping -- What you need to do

October 25, 2006

In July 2006, a barrel of Oklahoma crude oil was above $75, but has dropped to less than $59 since then, a 20% decline. However, the domestic supply of crude has been basically flat, rising less than 1% to 1.77 billion barrels. Many people have said that the government has manipulated the oil market by releasing oil from the Strategic Petroleum Reserves. However, these inventory levels have remained flat since July, at 687 million barrels.

While oil prices were falling, the stock market has risen. The Dow Jones Industrial Average, or Dow, has gone from 10,739 on July 14 to 12,116 on October 24, 2006. At the same time, demand for 10-year Treasury notes has increased. Higher prices paid at auction for these notes has enabled the U.S. Treasury to pay lower interest rates, which have fallen from 5.1% in July to 4.78% last week.

What It Means:
Despite all the conjecture about underlying supply and demand, oil prices are driven by investors as much as gold, stock and bond prices are. The price of oil starting declining in April, despite no corresponding change in supply or demand. Apparently, as investors took money out of oil, they bought either stock or Treasuries.

However, OPEC is considering reducing supply in an attempt to shock investors into buying oil futures again. If this happens, expect the stock market to fall, and Treasury note interest rates to rise. This will then delay the recovery of the housing market.

Action Steps:
The prices of investment classes are becoming less and less tied to underlying fundamentals, such as the supply of oil. As a result, it is more unlikely that you or anyone can accurately time the market. The only safe strategy is a well-diversified portfolio that has allocations of stock, bonds, real estate, and commodities such as oil and natural gas.

Source: Board of Governors of the Federal Reserve web site, Energy Information Administration web site