Why oil bulls may get burned

August 21, 2012, 3:00 PM UTC

FORTUNE — Wall Street money managers betting on a pop in oil prices could be in for a rude awakening.

This summer, the 22% spike in WTI and 30% spike in Brent, the two most actively traded crude price benchmarks, seem to be based more on fear and speculation than logic and fact. Indeed, it is not unusual to see such rallies in a volatile commodity like crude. The elasticity of the product means that if you don’t have it when you need it prices will instantly go through the roof. Anxiety over supply tends to push prices way beyond where they should be, and then the pendulum always swings back, crushing bulls in spectacular fashion.

But current worries over a possible war with Iran are overblown, as neither the West nor Iran seem truly interested in elevating the conflict beyond harsh words and soft demonstrations of power. At the same time, crude oil is backing up in commercial storage facilities worldwide on the back of increased drilling and weak demand growth. With the economies in the West and the East showing little signs of a quick recovery, demand for oil should remain weak — sending prices down, not up.

Taking a bath in the oil markets is one of the quickest ways of seeing a fund implode. But despite the countless disasters that have singed traders over the years, many hedge funds and asset managers have taken risky directional bets on the price of crude this summer. One can see this by taking a look at the CFTC’s commitment of traders report on crude oil, which tracks the buying and selling activities of money managers and other interested parties in the futures markets.

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The most recent report released on Friday shows that the number of money managers betting that oil prices will go up in the near future outnumber bearish money managers by a factor of five to one. The overall volume of trading is low given the summer, so the impact of the bullish bets have had a bigger impact on the oil price than they normally would if the market was fully staffed.

Traders cite a variety of reasons for the bet on higher oil prices. There are the geopolitical (a possible supply disruption emanating from an Israeli attack on Iran), the economic (a positive resolution of the euro crisis and a hope for more monetary stimulus in the U.S.), the fundamental (decrease in North Sea oil exports) and the social (everyone else is going long oil so I will too – at least for a while). Each one of these reasons is based on fear (geopolitical and social), false hope (economic) and ignorance of the markets (fundamental).

The markets are concerned about an imminent Israeli attack on Iran’s nuclear facilities and the subsequent fallout that would result. The fear is that Iran would retaliate against U.S., Israeli and Arab targets throughout the region, leading to a massive disruption in the supply of oil for months or even years.

The Iran question has lingered over the oil markets for some time now. Every few months there is a new report or a speech from a politician (Israeli, Iranian or American) that spooks the market into thinking war is at hand. What got the market moving recently were bellicose statements from Israeli Prime Minister Benjamin Netanyahu and Defense Minister Ehud Barak. Both said at the beginning of the summer, quite publicly, that they see the window for attacking Iran closing and that they would strike with or without clearance from the U.S.

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The Iran concerns were brought to an apex on August 10th when Haaretz, an Israeli newspaper, reported that Israeli leaders were considering a strike on Iran before the U.S. presidential election in November. The hope was that the “October surprise,” would force President Obama into supporting Israel so as to not look “weak” in front of the U.S. electorate.

But this fear of imminent attack has been alive for ten years now. It was August 14, 2002 that the world first learned that Iran had a clandestine nuclear program. The Iranian regime claimed that the program was for developing nuclear power, not weapons, but the markets never really believed that then, and doesn’t believe it today.

Like the boy who cried wolf, this whole issue has become stale and clichéd. Nevertheless, the fear of a Mideast war is just too great to dismiss, no matter how ridiculous it may seem. This has kept a premium, like insurance, on the price of oil for a while, which analysts speculate to be worth somewhere in the range of 10% to 20% of the price of a barrel. The premium fluctuates based on the headline risk as no one wants to be caught short if an attack comes. This explains why the oil markets have had a long bias for some time now.

But at a five-to-one margin, the proverbial pendulum seems to have swung too far over to the bullish side of the market. The latest boost in the oil price would suggest that war is just around the corner, yet that is hardly a certainty. For one, there are conflicting statements coming out of the Israeli government on this topic (as always). Just last week Shimon Peres, the President of Israel and the former Prime Minister, told reporters that he has great confidence in President Obama and that Israel would not attack Iran without U.S. help. The U.S. has maintained that an attack on Iran would only be considered after all diplomatic avenues have been pursued.

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In the meantime, the U.S. will hit Iran softly, as it has through the release of computer viruses into Iran’s nuclear facilities or through enforcing economic sanctions. Iran’s economy has taken a hit this year after the U.S. got serious about cracking down on banks that help Iran sell oil to its neighbors. This has led to the near collapse of Iran’s currency, creating internal dissent. Brigadier General Massoud Jazayeri, Iran’s Deputy Chief of Staff, told reporters last week that Iran and the U.S. had entered a stage of “total economic war.” That is probably as far as things will go here. If the conflict turns from cold to hot, and Iran strikes back hard against an Israeli attack, its economy would almost certainly collapse as the U.S. would shut down Tehran’s ability to export any of its oil (80% of its GDP). While some might consider Iran’s ruling clerics and generals to be irrational, they aren’t that irrational as to make the nation’s economic problems go from bad to terminal.

In any case, President Obama and UK Prime Minister David Cameron have signaled that they are not going to let oil prices rise indefinitely on this issue. Both have said that if oil prices rise high enough that they will authorize a release of oil from their strategic reserves. This has Saudi Arabia and the International Energy Agency up in arms. Both say that the market is well supplied and that it would be a mistake to dump product on the market to put an end to financial speculation. While that may be true, the U.S. election this November changes the equation.

Such a release, even a small release, would act as a toppling counterforce to the oil bulls, swinging the market pendulum hard and fast from long to short. That’s because, believe it or not, the world has a lot of oil in storage already and demand is weak. The IEA reported that inventories in the developed world have built above normal in the first half of the year, with commercial crude stockpiles at 82.4 million barrels. That is more than double the five-year average of 37 million barrels.

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Meanwhile, growth in demand has come nearly to a halt — the usual increase in oil demand from developed nations is now being offset by an almost equal decrease in demand from developed nations. For example, in the U.S., petroleum consumption was down 2.7% in July compared with the same time last year. Gasoline demand was down 3.8% during that same time period. That has to do in part to the sluggish economy, but it also has to do with how Americans live their lives today. Sustained high prices have caused people to permanently change the way they use oil, like shifting to more fuel efficient cars. This means the U.S. needs less oil to maintain the same level of productivity – a clearly bearish signal for oil prices.

There are dozens of moving parts to consider when betting on where the oil price will go next. Any number of triggers can cause the market to wake up and reverse all of its gains and then some. With war with Iran highly unlikely, it is difficult to argue that prices will climb higher than they already have. That leaves the market vulnerable to a fast and furious downslide. Money managers may be looking for an “October Surprise,” but it is more likely to come from a bull-crushing release of oil from strategic reserves than from a long-shot bombing raid by Israeli F-16s.