Spot oil price reached $83 dollar a barrel less than two weeks ago, but had ended last week at $71 a barrel. In the last two business days, it bounced back to $77. What’s the reason behind the oil price dancing all over the place? Putting aside the periodic flare up in military unrest in Nigeria and the recurrent modest strengthening in the euro against the dollar; there is a reason that has been building since August 2009 and affecting the oil price. This is the continuous decline in the offshore and onshore oil storage.

The oil floating in VLCCs over water reached about 87 million barrels in August 2009, a level  that could satisfy the world's oil consumption for more than one day.  It stands now at 27 million barrel and declining. Oil in land storage in the major oil-consuming countries is about half of what it was at the peak time of August 2009.

The reason for the shrink in oil inventories is the reversal in the oil price from a low of $ 32 a barrel in December 2008 to $83less than two weeks ago. The carrying cost between futures and spot prices has shrunk to 40 cents a barrel when at least 90 cents are needed to carry out a profitable arbitrage profit. In other words, the oil market has morphed from severe to modest contagion where futures price is not much higher than the spot price. If the market moves into backwardation where the spot is higher than the futures, then volatility should multiply. These changes should be a fertile ground for speculators and should not be far fetched, given the recent exceptionally high GDP growth in the United States. DGP growth for the fourh quarter was 5,7%, and the ISM index of Service Activity for January 2010 registered above 50 which means the service sector that makes up the bulk of the American economy has started to grow. All these postive signs should be translated into growth in demand for oil.

What is the implication of this morph in the oil market? The obvious reason is that oil markets will not have thick buffer cushions in the short-run. When news about resumption of the military tension in Nigeria comes out or a weakling in the dollar, the thin buffer cushion should lead to immediate spikes in the oil price.  The spike may not last long because of the high spare capacity in the oil-producing countries but it will be recurrent and would add to oil price volatility. What makes those short-run spikes so dangerous is the greed of the speculators who will figure out the price movements and send the prices higher than what the thin cushion calls for.