2011 has been so far a volatile year for oil prices. Oil prices started the year at the $80 levels, when it shot up to the triple digits level post the Libyan crisis, as 1.5 million barrels a day were cut from the oil market. The past couple of months has seen oil prices on the downward trend. In May, fears of a lack of global recovery (lower US growth, Euro debt crisis) caused questions about demand for oil, leading the price of the commodity to depreciate. Then came June, where supply was the issue rather than demand.

In the oil market in June, we saw two camps rising: A camp that wanted to see oil prices decline, and another camp that wanted oil prices to remain at the triple-digits level. It is not a fight between producers of oil and consumers, as the world’s biggest exporter (Saudi Arabia) was in the former camp, wanting oil prices to decline to reasonable levels. During an early June meeting of OPEC, Saudi Arabia pushed for an innotiative that would see OPEC’s prodcution increase by more than 1 mn barrels per day. Saudi Arabia was supported by Kuwait, UAE, and Qatar, while Iran, Algeria, Venezuela, and Angola opposed the measure. After failing to increase the production targets, Saudi’s Oil Minister called the meeting one of the most disasterous OPEC meetings. The Saudi’s, claiming that high oil prices diminish demand and global growth, went ahead and increased produciton. Kuwait’s oil minister also announced that Kuwait will meet the Global demand for oil. The riveraly between Saudi Arabia and Iran can also be seen politically, where the two nations are trying to control the region, especially turing these turbulent times.

Last week, The International Energy Agency (IEA) came out and said that the are releasing 2 million barrels of oil per day for 30 days to cover the Libyan shortfall, as these high oil prices are hurting global growth. This sent oil prices down by 5%. The IEA’s move is significant as the Agency has acted twice prior to its recent move, once in 1991 during the Iraqi occupation of Kuwait, and again in 2005, during Huracaine Katrine, when the US was in-need of refined products. Though the move is temporary, as the Libyan oil is thought to stay out of services until the end of the year. The IEA’s move can also be seen as a market stimulus, especially during the end of QE2, as the increased supply of oil will lead to lower oil prices, and higher economic growth.

Oil prices went down 12% in June, and are down 20% from their peaks.

Oil is breaking new highs on a daily basis. This is worrisome indeed as it exacerbates the evolving inflation story. That mere inflation story may transform into a scary stagflation theme if oil stays high or surges higher, thus, prematurely ending our infant economic growth story.

It is a time of celebration in Kuwait. This may be part of my optimistic view. Yet, a bigger part is actually based on fundamentals. I do not believe oil will maintain the current $114 level or rise further. To support my view, please refer to the charts below which put the contagion risk in perspective. Comforting enough, Saudi’s spare capacity can easily cover production disruptions in Libya and Egypt! Saudi, with minor help from Kuwait and the U.A.E., can also make up for Algeria’s production if it faces issues in the future.

When one combines the above data points with lower demand from slowing emerging markets and ample oil reserves in the U.S., we can deduce that the current rise in oil prices is a temporary fear-driven dislocation in the market. That is why I would recommend shorting oil at these levels.

What began in Tunisia and Egypt with long-term rulers ousted of office by the public has caused a hunger for revolution effect throughout the MENA region. In Morocco civilians marched in hopes of transforming the monarchy into a democracy, in Yemen, Ali Abdullah Saleh promised to undertake political and constitutional reforms, meanwhile in Bahrain peaceful protesters demand ouster of government. However, in Libya as violence escalates and becomes more widespread the aftershocks of the civil unrest are being felt across global financial markets.

Libya, the 12^th largest exporter of oil pumps 1.8 million barrels of oil a day. That’s about 1.8 percent of the world supply at risk. As a short-term shock, with the ongoing violent uprising threatening to disrupt oil exports, oil prices have jumped to the highest levels in more than two years at $96.08 a barrel. However, the long-term effect of the ongoing violence might be detrimental to the global economic recovery as rising oil prices might accelerate inflation.

How important is Libya to the world economy? Well, according to BP Plc’s Statistical Review of World Energy, Libya currently holds the largest proven oil reserves in Africa, roughly 44.3 billion barrels followed by Nigeria and Algeria. Oil and Natural gas make up 50% of the vountry’s GDP and almost 95% of its exports. What is most interesting is Libya’s strong economic relationship to the highly indebted PIIGSter, Italy. Eighty percent of its crude exports are sold to EU countries such as France, Germany and particularly Italy.

Flushed with petrodollars, Libya’s money was invested in Italy while Italian companies have enjoyed ongoing contracts for energy and infrastructure projects in Libya. Some of Libya’s holdings include a stake in Eni, Unicredit, Fiat, Juventus, and many other companies. While Italy is already in its own debt troubles, the situation in Libya only makes it worse.

Going back to the global economy, an important question remains and it is that will Saudi Arabia come to the rescue? Looking at history, Saudis have come to the rescue after the Gulf War when they boosted oil output by 2 million barrels a day, but will they come again?

It feels like the market wants to see oil at $100 per barrel with Brent crude hovering around it already. Yesterday was the first time oil prices rise above $98 since October 2008, as the Brent touched $98.46 briefly in London before falling back to $97.77 while the light sweet crude (WTI) rose to $91.74 in New York.

We were expecting oil prices to test those levels but no so quickly, with  $100 a barrel being only a matter of time. (Buy Oil Now?) The rally has been driven by the cold weather in Northeast US, drop in existing stockpiles, and the recent closure of the Alaska oil pipeline. Not to mention the rising speculation of slowing down production in the Gulf of Mexico by Obama’s administration by increasing the liability cap for damages when companies drill offshore. As for the long-term growth, the Energy Information Agency (EIA) states that global consumption of oil is expected to increase due to the resurgent demand driven by improving economies in both the developed and developing world. Forecasts also claims that oil demand is expected to reach 88.6m barrels a day during 2011 from 87.78m estimated last month. With the OPEC having no intention of increasing production and the fragile global growth, high oil prices can become a threat for the global recovery.

Naturally, the supply constraints and concerns of the leak sent a shiver down the oil markets pushing up prices of oil while holding down BP. BP stock took a beating as it owns a 46% stake in the Trans-Alaska pipeline and I believe the incident signals a buying opportunity for BP. Nonetheless, we aren’t exactly facing a major disaster similar to the Gulf oil spill as Alaska’s key pipeline has resume shipments and was pumping 400,000 barrels per day, almost two-thirds of its normal levels already.

Supply constraints are pushing up crude oil and increased global demand is expected to enable it to sustain elevated price levels; at the end of the day, BP will take part in the rally.

Many factors influence oil prices such as oil reserves, strength of the dollar, and the political atmosphere in producer countries. No one would argue against the influence of speculation on oil prices, however, the extent of this influence is the subject of constant heated debate. A recent research paper examined how changes in oil contract positions of hedge funds affect oil prices. It found correlation, NOT causation; leading us to believe that the extent of oil speculation influence is limited. Yet, the research was hampered by the fact that hedge funds are notorious for their secrecy and generally do not publicly disclose their trades.

Source: The Economist

The graph above shows that whenever prices increase; hedge funds would have a net long position. Whenever that position declines or goes negative; oil prices decline.

On a related note, Tuesday’s (July 7th) Wall Street Journal headline read “Oil Speculators Under Fire.” The article discussed how France and the UK are launching efforts to crack down on oil speculation. Further, it suggested that the US is pondering a similar stance.

In my opinion, any curtailing in the oil speculation market would lead to unfavorable circumstances. Such act will limit the oil market to just the suppliers and the end users (refiners, utilities companies, etc.). It will deny companies that are dependent on oil, such as airlines, the opportunity to take on hedges to limit their exposure to changing oil prices, thus, adding uncertainty to their earnings. Moreover, it will lead to a significant imbalance in the power of suppliers and end users since it removes an important middleman. Speculation usually smooth out the changes in oil prices as it increases the pool of oil specialists attempting to fairly price oil, and trying to take advantage of any arbitrage opportunities. A possible solution that could ease Washington’s worries would be to put a limit on speculative trades as a percentage of total oil trades, as is prevalent among other commodities.