A sign advertises the price of a gallon of regular grade gasoline at $1.98 at a gas station in Collingswood, N.J.
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With speculators' positions massively leveraged, holding only a fraction of the value of the oil they had purchased, they scrambled to cover losses. Not only did oil prices go down, but other assets also declined significantly. The further oil prices went down, the more deleveraging and liquidation had to occur to cover these losses. The financial crisis was the spark; deleveraging, the fuel. A chain reaction occurred as traders who had bought oil saw their money disappear in oil and other losing investments. And with a credit crisis looming, major players interested in maintaining a long position could not raise capital to cover margin requirements.
This deleveraging also occurred among investment banks. The failings of major financial institutions have directly fueled the decline in oil prices. Many banks' internal commodities-trading funds — Citigroup, for instance, owns Phibro, a major commodities trader — have generated excellent returns over the past few years.
Translation: the banks were long on oil and probably helped effect high oil prices. But with these banks failing, and prices already declining, they too closed out those long positions and helped bring prices lower. Oil prices may have risen on panic, and fear may have played a role in their recent fall. The mechanism of the fall, however, was a massive liquidation.
Where, might you ask, does demand and supply of the commodity come into play? Maybe in an economics textbook somewhere. Perhaps the credit crisis will slow demand somewhat, but certainly not enough to split the price in half. True, recession may be upon us, and that might help justify lower oil prices, but that fear is not the real story behind the fall. Remember: it was not great prosperity that doubled the price.
This is not the story of oil as a commodity but instead the story of traders who transact in the future price of oil. These are the same traders who previously brought this price to record highs. The price of oil went up tremendously; the price of oil crashed. Unfortunately for consumers, the story is not over yet, and we're just along for the ride.