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Whenever I'm puzzled about the price of oil I visit David Heard and he makes me a cup of tea to calm me down. He's half-way through Volume Two of "From Pearls to Oil," a fascinating story told by someone that is part of the action from the beginning. By the way be warned - Volume One, doesn't actually get to the part where oil was discovered which is a bit like watching a Bond Movie but there isn't a car chase at the end. And no he won't give you your money back if you complain, I did, he didn't even offer me a discount on Volume Two.

I asked him, "What's your prediction?" He hates that. After getting the standard five-minute lecture about the futility of making predictions he told me, "I wouldn't be surprised if the price drops." I said "OK, so how much, as low as $80 Brent?"

"Possibly quite a bit lower than that." That was it, admittedly there is not much information there, but for David, that's a speech. That's what I think too. My reasons are different and no, I didn't spend 50 years thinking about oil. My logic is simply that there is clear evidence of a bubble.

It's interesting that even though there is ample recent evidence that bubbles do actually happen, in real life, one of the characteristics of all bubbles is that when they are happening, no one see's them. Like a tsunami out at sea, you don't notice it. It's only when it hit's land that you know.

So what is a bubble? Right now the sellers are selling, the buyers are buying and as far as anyone can tell the market is working efficiently. Sure, perhaps the Saudis cut back a bit, perhaps the embargo on Iran made a difference, perhaps the world economy is growing more than the doomsayers think, perhaps the bankers are up to their tricks again, in other words, business as usual, that doesn't mean there's a bubble.

Except, everything has a fair value. According to me $100 Brent or more isn't it, something's wrong.

"Fair Value" is the price where the gain realized by the buyer is the same as what the seller got out of the deal. In efficient markets, both sides of every transaction win. Bubble and busts on the other hand are zero sum. There are winners who make money at the expense of the losers, net, no economic value is created.

This is how you can tell that the action from 2008 through 2009 was a bubble and bust. First, talking Brent, the peak of the wave was $140 or thereabouts, the bottom of the trough was $35 or thereabouts, the square-root of those two numbers multiplied together is $70. That's about Fair Value or the "fundamental."

Exactly where the "fundamental" was over that time can be worked out by multiplying the monthly production of oil worldwide by the difference between $70 or so and the price, according to the theory of Zero-Sum, the total amount of money paid out more than the fundamental, during the bubble, should pretty much equal the amount paid out less than the fundamental during the bust.

The line drawn on the chart which puts Fair Value about $77 defines that. Between August 2007 and August 2008 $167 billion was "over-spent" buying oil, between August 2008 and August 2010 $167 billion was "under-spent."

(click to enlarge)

At $77, (A) net the amount paid out too much (B) pretty much equaled the amount paid too little (C), the losers were those who paid too much in the bubble and the sellers who sold their oil too cheap in the bust.

The economic damage of bubbles and busts goes further than the winners and losers in the market. During the bubble investments are made predicated by the assumption that the high price will stay forever, in the bust these often must be liquidated at fire sale. Equally, during the bubble there is under-investment in energy-saving and in the bust there is under-investment in exploration and development, this often predicates further instability down the road.

Projecting the line forwards, two points. First, there has never been a point in recent history where the producers could not produce more oil, if they really wanted to, so "Fair Value" is determined only by what the buyers can afford to pay. That is called parasite economics, in recent history the amount of money that the world can afford to pay for oil is 3.3% of World GDP, divide that amount of money by the production, and you get the Fair Value. That's explained in graphic detail here:

World GDP (nominal) is growing at about 5%, production is pretty-much static, that means the trend-line growth in Fair Value is about 5% a year.

That says on 5th April 2011 oil was 40% over Fair Value, which says that at some point the price will fall to about 40% under Fair Value, if that happens in 2013 that will mean the bottom of the trough will be about $67 (Brent), if it happens in 2015, that will be about $72 (Brent).

When that will happen, is, like David says, futile to try and predict. What might trigger the reversal is the growing realization that America will be energy independent by 2030, f not sooner. That's a huge game-changer.

In the meantime, anyone who is contemplating an investment in exploration or production that won't pay-back if oil is less than $75 should be wary, so should anyone long oil service companies, or other industries that are sensitive to the price of oil.

Source: Evidence Oil Is In A Bubble