Paulson's comment about the speculation explanation was refreshing coming from a government figure. It deviated from the standard moron line that we attack the problem by attacking speculators and oil companies.

There are only 3 things that can happen to a barrel of oil when it is bought:

1. Contract delivery is taken and it is used
2. Contract delivery is taken and it is stored
3. It is sold before contract expiration

There is no speculation in #1. There is only short term speculation in #3. That leaves only #2, storage, as a playground for serious, persistant speculation. And storage isn't something you have to guess at or solve with charges about evil manipulators behind the curtain. Just look at a historical chart of oil storage (they keep track of it!) like the one I'm going to be posting next week with a look at all the shorting and "spec" longs that so many people use as an oil price prediction. If you look at such a chart, you find that there is a solid link between supply concerns and inventory levels. In the 70s, the run up in oil price was accompanied by some significant stockpiling of oil, which was undone in the mid 80s as the massive switch to smaller cars and a very bad recession finally cooled a runaway demand surge. This speculation aided the downdraft in oil that occured in early '86, when the high inventory level came sharply down and oil quickly went from $30 to $15.

In the 1990 Gulf War there was a much milder version of this. So what does this storage chart show now? It shows the oil price straying far away from any stockpiling activity. You here it often said that inventories are at their highest level in 5 or even 8 years. What these people fail to mention is that stocked oil, in terms of days of import disruption coverage, has been flat as a pancake at historical low levels for over 8 years now! There is nothing like the stockpiling episodes of the past going on. In fact, there is a strange disconnect between the historical lock-step movement between oil price and oil storage over the last 5 years. This point about speculation is further discussed by Gary Lucido at investingminds.com in the article "Oil Prices Not Driven by Speculators".

But what about all the wild gyrations in oil price we have been seeing the last couple of years? Has fundamental demand really doubled in a year? Doesn't this prove it's all just speculation? Econ 101 says that demand doesn't have to double for price to double. But as for the sharp price changes both up and down that don't seem to be linked to any fundamental like a production surge or demand ramp up, we may well be entering the condition Kenneth Deffeyes discusses in one of his books where, as demand approaches capacity, pricing becomes chaotic and volitile. It becomes a bidding war where a barrel of exported oil is worth whatever someone (or some government) is willing and able to pay for it similar to bidding on rare paintings at an auction. Here the price becomes disconnected from the normal supply/demand adjustments - you can't make up another batch of rare paintings just because more people want them. We are getting to the point where we can't whip up more oil supplies just because the demand is there. Predicting the gyrations in oil price may become like trying to predict what a rare painting will go for in the fickle hard-to-analyze minds of the bidders present.