Falling Oil Sets Trap

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 - commentary - Cramer's Take) 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."

---

Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].