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Oil Rally Defies Fundamentals

Stocks in this article: CVX BP USO

This week saw this report on oil stockpiles from Reuters: "Total U.S. commercial stockpiles rose slightly last week by 200,000 barrels to hit a new 20-year high just above 1.143 billion barrels, the highest level since the EIA began issuing weekly reports in 1990."

And yet, oil rallied in the last two weeks more than three dollars, as of yesterday trading $77.50 a barrel.

What can make supply increase to historic levels and still allow the commodity to rise in price? It is "oil's endless bid."

"Oil's endless bid" is what I have called the "assetization" of financial oil, working through index investment, ETF trading and dedicated energy hedge funds. They are all entering the futures markets without regard to the fundamentals that underlay the commodities.

Oil's Endless Bid is also the title of my upcoming book from John Wiley and Sons, discussing this topic, which I believe is the most important financial story of the decade. But this week's EIA report draws this disconnect into such sharp and immediate focus.

Let's discuss "oil's endless bid" briefly and try to understand how oil can rally while supplies continue to bulge.

Commodities aren't stocks, but the financial industry has worked hard to make them look and work as if they are: They've created indexes, ETF's and managed funds that allow investors to access the price of the crude barrel as if it were a share of Chevron.

And the investing public has glommed onto the products with both fists, causing index investing in commodities to increase more than 25 times between 2003 and 2008 to over 300 billion dollars in funds and increasing the number and market caps of futures based ETFs as well. The market-leading US Oil Fund (USO) has had three share expansions since its inception and now trades an average of more than 9 million shares a day.

All of this investment interest in oil has swamped out the traditional users of the financial oil market - the oil companies and commercial end-users - and turned the price discovery mechanism into just another capital market, under influence from unrelated financial inputs and moving on the whims of investor perceptions.

I could point out literally dozens of short-term economic pressures over the last several years that have had no impact on the fundamentals of oil, yet have had enormous influence over the price of oil, one of the latest being the BP oil spill, which momentarily scared investors away from oil investment and saw the price drop more than 25% in less than three weeks in May.

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