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Falling Oil Sets Trap

Editor's Note: This is a bonus story from Barry Ritholtz, whose commentary usually appears only on RealMoney . This column was originally published at 3:29 p.m. EST Tuesday. We're offering it today to readers. To read Ritholtz's commentary regularly, please click here for information about a free trial to RealMoney.

Having mulled over a variety of possible outcomes with oil and its impact on equity markets, I cannot shake one troubling scenario that I call the "oil trap." It keeps coming up as I consider various crude price moves. What is so dastardly about the trap is that it sets up both bulls and bears for heartache.

Unfortunately, I consider it a very high-possibility scenario.

How the Trap Got Set

As someone who has been bullish on oil since December 2003 -- and mentioned a $57 target here in late-September 2004 -- my expectations have been met, even exceeded. I am now comfortable stating my expectations of an intermediate-term oil top between $57 and $59; Tuesday afternoon, crude was recently down $1.46 cents at $56 per barrel.

I expect the stock market's response to a pullback from these levels to be positive, but short-lived.

Consider the course oil took to reach these levels over the past two years -- it's almost, but not quite, funny. Oil bears -- the ones who were so negative when crude was between $40 and $45 -- have suddenly found religion. I recall hearing repeatedly about a $20 "terror premium" built into crude, and that there was a $15 bump caused by the speculators. I even recall hearing that the Chinese economy was about to nose-dive, thereby implying a dramatically reduced demand for oil.

Indeed, I have heard every "excuse" for the price of oil being what it is -- except for the one that matters: a gradually improving global economy, with expansion concentrated in Asia, particularly in China and India.

But when oil passed $50 on the way to $55, an intriguing sentiment shift occurred: The oil bears suddenly became rip-roaring bulls. That is a small part of the reason I suspect we are now entering what academics refer to as "the stupid phase." We hear calls for $80 and $100 crude, and note that firms such as ExxonMobil (XOM) gained nearly 20% last month. This amounts to an unsustainable extension of gains for the energy sector.

Oil has now become a crowded trade. Recent Commitment of Traders data show the speculators have shifted to net long crude futures and options, as opposed to a more recent position of nearly "net flat."

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