Oil down below $138

Yesterday, oil fell the most in one day since the start of the Gulf War in January 1991 to close at $136.03 in New York trading. Now is the time to evaluate whether we have seen the top in oil prices? On Thursday in my post “Oil close to $146” I said,

The price action makes me think we are nearing the top here. I’d call $150 a peak. Many have called a peak before so let’s see what happens going forward.

I would like to reiterate that sentiment here with oil still being quoted below $138 in overnight trading. As I see it, a tight supply due to low Iraqi output from the war in Iraq, refiners’ inability to process heavy sour crude, and peak oil production led to a super spike in oil prices. The response has been demand destruction in the North America and Europe coupled with a reduction of oil subsidies in Asia.

Ultimately, the oil-induced inflationary spiral combined with the financial crisis has brought the world to the brink of recession with economies slowing markedly in Europe, North America, ANZ and South Africa. Demand for oil is lower, so prices will soon follow.

This begs the question whether inflation is still anything to worry about. My answer is yes — but not because of actual commodity prices, rather because of much higher inflation expectations getting embedded in the economy. There is always the worry about a confrontation with Iran bringing oil prices back up again (and way up potentially). But on the whole, demand destruction has set in and I expect to see oil prices lower.

If oil prices continue to fall down below $100, we can see the super spike as over. I see oil collapsing to well below $100 in the not too distant future.

Then we can move past inflation to the real worry, deflating credit and asset prices.