After historic jump in Oil price, what comes next!

Oil’s jump makes history, but true test is yet to come

By Myra P. Saefong, MarketWatch

SAN FRANCISCO (MarketWatch) — Crude-oil futures made history Monday with the biggest daily dollar gain ever seen on the New York Mercantile Exchange, but the true test for oil is yet to come.

The future of global oil demand is more uncertain than ever given the U.S. rescue plan for the financial market, and no one’s sure about the impact and recovery pace of production and refinery activity in the Gulf of Mexico following the recent hurricanes, analysts said.

On Monday, a steep drop in the U.S. dollar, assumptions that the government rescue plan will help improve the economy and boost oil demand as well as short-covering related to the expiration of the October crude contract on Nymex all combined to pull oil prices to their highest intraday level in two months. See Futures Movers.

Oil’s rally was “a mixture of short covering and the growing realization that the Fed [especially in an election year] is willing to be the ultimate backstop to the economy,” said Neal Ryan, a managing partner at Ryan Oil & Gas Partners.

“Throw in a worsening supply/demand dynamic on top of it and we’re off to the races,” he said.

It all just “underscores that energy is the only place to expect outsized profits these days and the money is flocking into that market,” he said.

U.S. stocks dropped Monday as traders digested the details of a $700 billion plan to rescue ailing financial firms. See Market Snapshot.

“Clearly the money out there needs a place to go, and oil is now a major safe haven,” said Michael Lynch, president of Strategic Energy & Economic Research (SEER).

Illogic

But some of what’s going on really doesn’t make any sense. A worrisome economy and financial market should translate into lower demand for oil, some analysts said.

“The oil market is caught up in the same hysteria of the rest of the financial markets,” said Anthony Sabino, a professor of law at St. John’s University, whose legal practice includes oil and gas law.

“We can and will get through this” as the markets did back during the Great Depression in the 1930s, he said. “So oil traders getting caught up in the general panic is just plain dumb.”

“If the economy is so bad and uncertain and panicky, [the] price per barrel should be deflating like crazy because demand is cratering,” Sabino said.

The same insane speculation that drove investors into “toxic investments” such as subprime lending and collateralized debt obligation has infected the oil market, “so for no good reason at all they are driving oil up to unsustainable prices,” he said.

It’s a “wholly illogical disconnect,” Sabino said. With the U.S. stock market down by so much and money tight, logic says oil demand will “continue to drop like a stone, so prices should be back at $90 and heading south to $80.”

Complications

Complicating matters on Monday was trader short covering related to the expiration of the October crude contracts on Nymex, analysts said.

“Some folks got caught short,” said James Williams, an economist at WTRG Economics. “The stocks at Cushing [Okla.], which is the delivery point for Nymex, will be low because they have been drawn down because of the hurricane.”

So “if you are short on the last day of trading you have to either buy back the contract or make physical delivery and it is probably difficult to get spot oil at Cushing to make physical delivery,” he explained.

Confidence in the commodities also climbed on the heels of the drop in U.S. stocks and as the dollar buckled against other major currencies. See Currencies Report.

“A weaker dollar on concern about the financial crisis and how Congress will handle it, as well as a flight to safety — or at least the perception of safety in a commodity that has increased for five years,” helped pull prices for oil higher Monday, said Williams.

Longer term, however, oil should see pressure from the weaker economy worldwide, he said. “Even China is trying to stimulate its economy.”

And don’t forget: The Gulf of Mexico’s still slowly recovering from Hurricane Gustav in August and Hurricane Ike in September.

About 76.6% of oil production and 65.5% of the natural-gas output in the Gulf are still shut in as of Monday, according to the U.S. Minerals Management Service.

The hurricanes and the energy facility shutdowns related to them didn’t appear to contribute much support to oil prices. Historical prices for crude on Nymex actually fell about 10% between Aug. 19 and Sept. 19.

Sure, oil seems to be a major safe haven now, but how the oil market reacts “when inventories go up as the effects of Gustav and Ike diminish will be the real test,” said SEER’s Lynch.

Myra P. Saefong is MarketWatch’s assistant markets editor, based in San Francisco.