The Oil Bubble Is Popping, But Will It Pop Down To $67?

Includes: OIL, USO
by: Andrew Butter

The story so far:

1: There was a bubble in oil prices in 2008. The evidence for that is it popped which is a pretty good clue, although so far no one has figured out what drove the bubble. Yes it was probably speculators with access to easy money, but sadly no smoking gun has been found, although one gets the impression no one looked very hard.

2: The bubble popped, like bubbles tend to do, and then the price drifted back to what appears to have been the "equilibrium" at the time of $80 to $90 a barrel if you are talking Brent. Although by that time too Brent and WTI de-coupled so there is a bit of uncertainty about which line you should be following - if either using your genius model which was based on a history when WTI used to sell at a premium to Brent.

Regardless, the dynamic of the bubble - blow-pop-recover - looks about as perfect an example of the "theory" of BubbleomiX as you will find anywhere, in that the equilibrium [E] looks like it pretty much equals the square-root of the minimum [M] multiplied by the crest [C]:

E = √MC

As is explained in the seven Immutable Laws of Bubbles here.

That is reminiscent of that other General Theory, and I'm not talking about Keynes' one, by the way, and of course that doesn't mean it's right.

3: What followed looked suspiciously like another bubble, with causes still as mysterious as the cause of the first bubble.

4: But after a bit of a wobble, it looks suspiciously like that one is popping too.

This is a chart I put out at the end of March 2012 which I have updated and annotated, which summarizes the action so far (here):

(Click to enlarge)Click to enlarge

That article started ...

If oil prices don't crash down to $67 within the next two months, that means for sure the evil one-eyed-drooling-spirit of peak oil, which everyone has been studiously trying to ignore for so long, has finally arrived.

The next day prices started to fall, but they haven reached $67 yet.

That was based on a theory, that also said in May 2011 that there was a bubble and it would pop, which it sort of did, but not down to $67 (here).

That time, the price went down ... but not to $67. So on the face of it there is something wrong with the theory, unless peak oil is upon us.

The idea there is (if) there wasn't a pop (then) that would mean peak oil was starting to be a reality, in which case the price of oil would start to be dictated not by what the customers can afford to pay which many people agree is about 3.3% of nominal GDP (so divide that by production and you get to price - that's called parasite economics).

Instead, if the game changes, then the price will be driven by the expected cost to discover and then develop and then transport oil that hasn't been discovered yet ... the cost to replace the stuff that has been discovered so far. So, if there isn't a pop soon, that means peak oil has started to be a reality.

That idea is explained in my 10-year forecast for oil prices which says FOOT = 3.3% TOAD/OIK (here).

So if the theory is right, then the mini-bust mid-2011 might actually get properly expressed in ... mid 2012? Or maybe not. Looks like the timing of the reversals correlates pretty well with summer blues; that could be what's happening this time. But if Brent goes down through $90 then this time, it might just keep going.

That will be good news for the spluttering Western economies, particularly the U.S. which hugely subsidizes the real cost of consuming oil, and pays for that by selling its birthright either in U.S. Treasuries, or (previously) AAA rated collateralized debt obligations which had the advantage of being non-recourse, but sadly the supply of dumb aliens willing to buy those seems to have dried up in recent years.

The subsidies in the Land-of-the-Free-Lunch (for the 2% with connections) were a crony capitalist hangover from the days when the U.S. was more or less self-sufficient in oil. The good news there is apparently, these days, fuel consumption is the major thing new car-buyers are looking at, and finally, with shale-gas so abundant the smarter people are starting to talk about using that to replace oil in trucks, and perhaps some cars.

A pop will also be good news for oil exploration companies too. That's because if the pop is cleanly expressed this time, that will demonstrate pretty conclusively that $70 Brent is the bottom line, and that $90 to $100 is where the equilibrium is, as opposed to the possibility oil will go to $40 and stay there which would kill large-scale investments that have five to 10-year pay-backs.

Of course if there isn't a real-nice pop, then that will be a sign peak oil really is coming to town, which is really good news for anyone who has the capability to find new stuff.

Interesting times.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.