Part I

During the insane summer run-up in crude oil prices, I did a series of articles on the inevitability of a crude oil price pullback.

Who knew that it would be this hard and this fast?

I'm sure that if we asked 100 oil business execs and oil analysts in June if crude could be trading in the 50s in less than five months that 100% of them would have said, "No way." And then they would have looked at us like we had just suggested a plan for immediate peace in the Middle East. Or a way for the Cubs to win the World Series.

Yet here we are, $57 and change with price in a downward spiral.

Why the monstrous drop? Is it the demand drop that everyone has been talking about this morning? Demand has fallen at least 1.3 million barrels per day globally (that estimate seems very conservative to me; crude supply and demand numbers are notoriously fudged because most of the world's output is controlled by central governments). But with the OPEC countries producing around 30 million barrels per day, that certainly can't be the main reason for the 60% drop in crude prices.

How about the fact that the U.S. dollar has strengthened considerably in the last few months as currency has undergone a "flight to quality"? Here's a weekly chart of the US Dollar index.

See charts at oneminutetrader.com

It's plain to see that the dollar is at its highest point since the spring of 2006. But in this index measuring the dollar against a basket of U.S. trading partners' currencies, the dollar is only up 17% in the last few months. So while this certainly plays a part in the dropping price of crude oil, it is not the major reason for fall. To drive home that point further, let's look at the price of crude denominated in another hard asset- gold.

See charts at oneminutetrader.com

Back in June, I highlighted the fact that an ounce of gold would only buy 6.5 barrels of oil - a multi-decade (if not all time) low. How is that ratio playing out now? I'm glad you asked, since I just happen to have a chart handyChart available at oneminutetrader.com

This month, gold has been able to buy almost 13 barrels of oil at the ratio's highest point. That's a huge jump of 50% in a short time. But since both commodities are denominated in dollars (and both have had steep price pullbacks in the last five+ months), this chart shows that oil's price has dropped twice as fast as gold's.

So if neither the drop in demand nor the strengthening dollar tells the whole story, what else adds to the case for dropping crude oil prices?

In Part II, we build the rest of the case for crude oil's big drop. (Here's a hint: don't expect the prices to stay on this severe downward course for long. We're already due for a reaction to the upside.)

Part II

Driving home from the airport yesterday, I paid $1.84 for a gallon of gas. I felt like I was in a time warp. These are gas prices from back when the Yankees had a good baseball team

Just a few short months ago (during the summer), gas prices were shaping up to be THE defining issue of the presidential election. Then the credit markets crashed and the health of the broader financial system quickly pushed crude oil and gas prices down and pushed news about the cost of filling a gas tank off the front page.

The drop has been amazing - here is a chart that I really like. The source of the data is the Department of Energy weekly survey. Take note of the time scale for the graph; it is very compressed and shows over 40 years of data. This is important because you'll see that the incredible gains that took many years to get us up above $4 per gallon were erased in a matter of a few months.

See Chart at oneminutetrader.com

I'm sure very few people are overly sad about the drop in gas prices (and now heating oil prices). In fact, this huge drop has helped ease the pain of the financial woes brought on by the credit crisis.

And oil prices continue to drift lower, with crude oil futures trading as low as $53.66 per barrel - down more than 65% from the July highs.

Previously we talked about the part that weakening demand and the strengthening dollar have played in the drop in oil prices. But few people have talked about the bubble-like ascent of prices. There a was an oil bubble and its end was like that of any other bubble. Technical and sentiment indicators were screaming, "Overbought! Overbought!" right up to the top.

So, yes, demand and dollar valuations did help drop oil prices - but they only account for a part of the fall. Most of the fall can be explained in this way - when bubbles burst, buyers flee. And prices drop harder and farther than could ever be expected. Next week, we'll look at some of the technical analysis and sentiment indicators that signaled a bubble.

But for now, the crude oil market is getting very oversold - the pendulum has swung the other way. Here's a chart that illustrates the point:

See chart at oneminutetrader.com

The notes in the chart highlight the key points: Momentum indicators are divergent at current price levels, including my favorite Chaikin Oscillator, which shows that money is not flowing out of this instrument as fast as it was a couple of weeks ago. In addition, we're staying way oversold on the stochastic and volatility is clearly decreasing.

With these things lined up, it's a tough bet to say there's a lot of downside left in crude oil in the near to intermediate term time frames. A rounded bottom or a fairly violent spike up would seem quite likely from here.