How to profit from falling oil prices

Remember back when oil prices were rising?

Every single day, every last increase in dollars per barrel, could be accounted for by the pundits. Oh, oil's up today because the Israelis looked like they might be thinking of bombing Iran one day. Or rebels in the Niger Delta blew up another pipeline. Or the US stockpile data came in unexpectedly low.

There frequently wasn't much to any of these stories, but unfortunately journalists can't just write "oil went up today for no particular reason", so they always find some reason for prices moving to stick in their market reports.

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Yet in the last few months, we've seen some really quite worrying developments, both in geopolitics and in the weather.

We've seen a battle in Georgia, which is very much about oil, and which has driven relations between Russia and the West down to levels not seen since the Cold War.

We've seen not one but two hurricanes threaten the Gulf of Mexico, disrupting oil production, even if thankfully we haven't ended up with another Hurricane Katrina scenario.

And we've seen a lot of sabre-rattling from the more excitable Opec countries about cutting oil production to prop up prices.

Now, back when oil was at $140 or so a barrel, and predictions were ranging as high as $250 a barrel, just a few short months ago, any one of these events would have sent it soaring. But now, with oil coming back down to earth, we've seen nothing more than minor bounces in the price after each incident, only to be followed by renewed strong falls. In fact, Brent crude fell below $100 a barrel yesterday, after it seemed that Opec would maintain production targets.

However, now the oil cartel seems to have reached its pain threshold. It's decided to step in and cut production, to try to prop up the market at the $100 a barrel level. Will it work?

I suspect not. As fund manager Testsu Emori of Astmax in Tokyo tells Bloomberg, "the current price is due to slower demand, not oversupply." In other words, the oil price is falling because people aren't using as much, not because Opec is pumping too much. Any production cuts will just be chasing demand lower.

Also, much of the money which, some argue, chased oil prices higher is now fleeing the market. A full $39bn of oil futures were sold by commodity index investors between July 11th and September 2nd, according to Michael Masters of Masters Capital Management. Masters has argued that limiting traders could cut oil prices to $65-$70 a barrel.

Since the start of this year, we've been concerned that the price of oil would fall as global demand slowed. At the start of August, we suggested that one way to profit from oil's falls would be to buy the Short Oil ETF (SOIL), which rises as the oil price falls see The oil bubble bursts for now for more. Even now, that still looks a reasonable bet. Oil could fall as low as $60-$70 a barrel without breaking its long-term uptrend.

That might mean that inflation pressures start to ease towards the end of this year and the beginning of next. But it doesn't mean that our oil problems have suddenly gone away. Demand might be falling now, but the Peak Oil argument still carries a lot of weight. The recession won't last forever, and in the longer term, oil prices will remain high and may well go higher, unless we find alternatives.

The good news is that while oil prices remain high by historical standards, that's exactly what we'll keep doing. You can learn more about the resurgence of interest in electric cars and how to invest in them here: Profit from the resurrection of the electric car. We also wrote about how to make money from Britain's search for a reliable, independent energy source in last week's cover story Why the future is nuclear. If you're not already a subscriber,subscribe to MoneyWeek magazine.