Investors Cautiously Optimistic as Oil Prices Drop and Markets Rally

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Prior to 3 July it appeared that there was no stopping the rising oil prices and, understandably, many investors began to despair. The elevated oil price was one of the factors behind the prevailing bear market, and stock exchanges began to feel the negative effects of the resultant decrease in trading volumes. The general consensus has been that investors should be patient, sit tight, and wait for the bear to leave town.

But, in another spectacular demonstration of how unpredictable and volatile the market can be, after peaking on 3 July, the oil price has dropped by more than $20 per barrel, with an almost immediate response from investors as evidenced by the subsequent stock-buying spree. Certainly the drop in oil prices is a welcome relief to U.S. consumers and companies alike, who have been dealt blow after blow with the mortgage crisis and credit crunch, as well has having the underlying fear that inflation could spiral out of control. At least with the drop in oil prices, which has been the key driver of the stock market for a while, the inflation fears can been put on the back-burner for the time being.

The Dow bottomed out at 10,963 on 15 July, which was almost 23% off the high in October 2007, placing it firmly in bear market territory, which is determined by a drop of 20% or more. However, since 15 July the Dow has risen 670 points (6.1%) which has bolstered hopes that this downturn will not be as devastating or as long-lasting as initially anticipated. Other positive contributing factors include the better than expected second quarter profits from many of the U.S. banks and brokerages, as well as the assistance offered by the government to Freddie Mac and Fannie Mae to ensure that they carry on with business as usual.

So what caused the price of crude to drop? Some analysts are of the opinion that, while there are likely many contributing factors, one of the biggest is that a number of large investors, such as pension funds and hedge funds, pulled money out of the oil market when it became evident that demand for oil was weakening both in the U.S. and overseas. This weakening demand was confirmed by the Energy Information Administration on Wednesday when it issued a statement that gasoline demand had fallen by 2.4% over the period of the past four weeks, showing that consumers were responding to the higher prices by actively making efforts to cut their gasoline consumption. Another contributing factor is that, contrary to earlier fears, Hurricane Dolly does not pose a threat to U.S. oil platforms. Moreover, with oil being priced in dollars, the stronger dollar is making oil more expensive for buyers using other currencies.

Analysts and investors are hopeful that the market rally will continue, but generally agree that much depends on the continued reduction in oil prices, a reduction in interest rates and the stabilizing of house prices.

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