Possible Reasons for the Dramatic Drop in Oil Prices

During a time of rising gasoline prices, the comedian Jay Leno quipped: "I bought a gallon of gas, as an investment." He probably did not anticipate that this sentiment could one day be a factor in causing oil prices to plunge, as they have recently.

Why has the price of oil dropped more than 50 percent over the past year? Two obvious culprits are our old economic friends, supply and demand. On the supply side, increased production in the U.S., along with the return of production in such places as Libya, has made oil more plentiful. On top of this, a sluggish world economy, especially in slower-growing China, has lessened demand. The result is lower prices.

But the folks at Morgan Stanley argue that these trends have been taking place for a while and are insufficient to explain the current situation. They point to a report by the Bank for International Settlements (BIS), which argues that oil has been behaving less like an essential fuel and more like a financial asset.

As Morgan Stanley explains it, "more and more, oil is purchased not for practical use as a fuel, but by financial interests who plan to store it and wait for the price to rise. Today, the daily volume of trade in oil exceeds the actual demand for oil by twenty times, up from just five times a decade ago. That is striking proof that financial speculation in oil has exploded." The BIS concludes that because oil behaves like other financial assets, oil prices are more susceptible to wilder price swings based on market expectations.

Morgan Stanley suggests that the financial speculation in oil was precipitated, in no small part, by the Federal Reserve's policy of low interest rates and quantitative easing over the last several years. A good chunk of this cheap money found its way into oil. Moreover, since oil is priced in dollars, a strong U.S. dollar has led to lower oil prices.

The implications of tumbling oil prices are varied. It clearly reinforces the notion that the investment world is complex and nothing is certain. Remember when tech stocks could do nothing but go up in the 1990's, until the bubble eventually burst? Likewise, energy -- hailed as the investment for a new era -- appears to be subject to market forces and unforeseen circumstances.