Geopolitical events are once again roiling the oil market, causing the fear factor to push the price of the commodity higher and leading commentators to trip over each other as they jockey to predict soaring oil prices over the next few years. (For related reading, also take a look at What Determines Oil Prices?)

TUTORIAL: Economic Indicators To Know

While some investors may be tempted to jump in and invest directly in the volatile oil market, the sands can shift quickly in a market dominated by short-term investors. Here are seven reasons why you might want to stay away.

1. Supply Response
The escalating investment in oil exploration and development will eventually provoke an excess of supply to hit the market. It's hard to predict when this will occur, but in our hearts we all know this will happen eventually. The talking heads on television seem confident that supply will never be enough to meet the insatiable demand from the emerging economies, but remember these were the same smart guys who told you five years ago that natural gas production in the United States would never increase enough to make a difference. Ten years ago they were telling you that no amount of bandwidth was enough to meet demand.

2. Momentum
Momentum is playing a large role in the recent increase in oil prices as strong price gains generates more headlines and draw even more investors into the game. While it might be fun to watch the price of oil move higher due to a technical breakout, the nomenclature used here implies a lack of fundamental support behind the move. Unfortunately, this momentum can cut both ways and oil can drop in price just as quickly as it moved up.

3. Too Much Capital
Capital is flooding into companies engaged in oil exploration and development as the frenzy of investor interest builds to a crescendo. There has been a capital frenzy in other industries over the last decade and that these episodes often end badly for most investors. While some dreamers would like to believe that the capital markets are efficient at allocating funds, this function is imperfect and usually falls short.

4. Consensus
Buying oil and other commodities is the consensus point of view among many investors, both institutional and retail, and experience indicates that the consensus viewpoint is typically the incorrect one. This consensus is usually reinforced by groupthink, social proof, confirmation bias and a host of other behavioral issues that operate just below most investor's consciousness.

5. High Expectations
Investors have high expectations on the returns that they will generate from oil and other commodities. A recent survey conducted by Barclays Capital indicates that 28% of investors expect annual returns over the next five years to exceed 10% each year. Another 60% of investors are looking for returns between 6% and 10%. Will such high expectations inevitably lead to disappointment and a rush for the exit?

TUTORIAL: Commodities

6. Manipulation
A frequent charge by some pundits is that the price of oil is manipulated by speculators and other large financial players in the market. Although there is scant evidence that would be admissible in court to prove this allegation, gut instinct tells many investors that there is probably some validity to this claim.

A quick review of the financial history of the United States and other countries reveals many instances of the manipulation of commodities, stocks and other financial instruments at various times over the last few centuries. While regulation and government oversight is much improved over the years, so is the cleverness and technology available to traders in this market.

7. Weak Investment Thesis
The investment thesis that supports the oil and commodities boom is that the growth in demand from China and other emerging economies will keep prices moving higher as operators struggle to generate the extra supply needed. This thesis is fragile and rather simplistic, which is probably why it is so often repeated in the media.

My experience as an investor is that when you take a current growth rate and project it far into the future and build an investment case on that basis, something horrific will usually occur. This same logic has been appended to the growth of the internet, personal computers, bandwidth and many other areas, only to later have this growth implode.

The Bottom Line
One interesting part of the Barclays Capital survey was the question that asked what the main concerns are of institutions that invest in oil and commodities. Over 50% cited "China risks" or "price bubbles" as the primary worry, perhaps implying that many of them do not have a firm belief in the fundamental story that supports oil prices.

Although oil investing appears exciting to many who watch in envy as others get rich, it may be a dangerous place to stay in the long term. (For additional reading, also take a look at 4 Benefits Of Rising Oil Prices.)

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: U.S 12 Month Natural Gas

    Learn about the United States 12 Month Natural Gas Fund, an exchange-traded fund that invests in 12-month futures contracts for natural gas.
  2. Options & Futures

    Analyzing The 5 Most Liquid Commodity Futures

    Crude oil leads the pack as the most liquid commodity futures market, followed by corn and natural gas.
  3. Economics

    Understanding Organic Growth

    Organic growth is the increase in a company’s revenue and value due to internal operations.
  4. Economics

    Explaining Market Penetration

    Market penetration is the measure of how much a good or service is being used within a total potential market.
  5. Economics

    Calculating the Marginal Rate of Substitution

    The marginal rate of substitution determines how much of one good a consumer will give up to obtain extra units of another good.
  6. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  7. Stock Analysis

    5 Reasons Thoratec Corp. Keeps Impressing Investors

    Learn about Thoratec Corporation and its position in its industry. Understand five key factors why the company has impressed investors.
  8. Entrepreneurship

    Startup Analysis: How Much Is Palantir Worth?

    Learn about the private company Palantir, its valuation and how its valuation was derived. Understand how the company operates and if it deserves the valuation.
  9. Chart Advisor

    Traders Step Back to Assess Commodities Damage

    Traders are turning to these exchange-traded notes and exchange-traded funds to analyze key commodities and determine what could be coming next.
  10. Stock Analysis

    Jawbone: An IPO You Should Have on Your Radar

    Learn about the company Jawbone and how it has become successful with multiple product lines. Understand the benefits of investing in an IPO
  1. Sticky Wage Theory

    An economic hypothesis theorizing that pay of employees tends ...
  2. Normal Profit

    An economic condition occurring when the difference between a ...
  3. Supply

    A fundamental economic concept that describes the total amount ...
  4. Black Money

    Money earned through any illegal activity controlled by country ...
  5. Horizontal Merger

    A merger occurring between companies in the same industry. Horizontal ...
  6. Factor Market

    A marketplace for the services of a factor of production.
  1. How can the federal reserve increase aggregate demand?

    The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure ... Read Full Answer >>
  2. Is there a difference between financial spread betting and arbitrage?

    Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >>
  3. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  4. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
  5. What does marginal utility tell us about consumer choice?

    In microeconomics, utility represents a way to relate the amount of goods consumed to the amount of happiness or satisfaction ... Read Full Answer >>
  6. What bond indexes follow the supply and demand for junk bonds?

    Bond indexes that track junk bonds include the Merrill Lynch High Yield Master II Index and the S&P U.S. High Yield Corporate ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!