Is This Oil Bubble Going to Deflate?

Last week, oil futures topped out at around $135 on news that everyone thinks that a barrel of oil is going to $150, $200, $500, or even $1million. However, some important, telling data late last week led to a pullback that may lead to something more significant.

Late in the week, the Department of Transportation reported that the number of miles driven in March fell by nearly 5% year-over-year. That five percent decline is an enormous number of miles – about 11 billion. The 11 billion miles not traveled saves an enormous amount of gasoline - assuming 20 mpg (which may be too optimistic), 500 million gallons of gasoline weren't burned during March.

That huge decline may signal a serious shift in the willingness of Americans to pay for gasoline. As gas crept up from $1.xx per gallon a decade ago to about $3 nine months ago, consumers complained. However, simply complaining doesn't keep any money out of sheiks' pockets, and Americans kept purchasing the necessary gas to get to work, take a trip to the mall, or run endless amounts of single errands.

However, as economic conditions worsened in late 2007 and early 2008 while gas prices continued to rise, consumers finally complained with their proverbial pocketbooks, and actually altered the way that they live their lives. It appears as though $3.50+ gasoline IS finally enough to alter driving and living habits for many penny-pinching drivers.

Econ 101 (it's actually Econ 102 at Penn State) preaches that gasoline has a relatively inelastic demand curve – that is, since it's so necessary to basic life in the U.S., consumers don't change their purchasing habits very quickly. (Think about it – even if gas was $10/gallon, could you stop commuting to work/school tomorrow?) Usually, it takes a long time for inelastically-demanded goods to exhibit weakening demand, as over a long period of time, people can find alternative solutions (ride the bus, move closer to work, buy a more fuel-efficient vehicle, etc.). The quick 5% drop seems to boldly state "enough is enough."

Clearly, sentiment has been changing for years as car companies now advertise MPG, not just horsepower or number of cup holders. Dozens of models of hybrids are now sold (and Toyota's (TM) Prius, the best selling and most efficient hybrid, just passed the 1 million mark), and the aforementioned complaining has been becoming louder and louder. Oil executives were crucified on Capitol Hill last week (though I think that the parading and harassing is an insult to the intellects of Americans, if legislators believe that finger-pointing [at the wrong people] will make Americans feel better).

There is also talk of raising margin requirements on energy trading, which basically would lessen the value of the bets being placed on the price of crude (and other commodities). A bigger issue, in my opinion, is the funny money in ETFs like Barclays Bank PLC (OIL) (which tracks the price of oil) and PowerShares DB Agriculture Fund (DBA) (an agriculture index), which purchases the hard commodities with money from individual investors. The massive amounts of money being pushed into such ETFs have artificially raised demand for the underlying futures, increasing prices further.

As perma-bulls cite ever increasing demand for petroleum as why it just can't go down, the DOT statistic pokes a big hole in their arguments. Yes, the third world will use more oil as people can buy cars and agriculture is mechanized. However, a movement towards efficiency in the United States will have a meaningful impact on worldwide consumption and could offset any increases in developing nations. If oil does stay at $130/barrel in an environment of commodity (and overall) inflation, all of the millions of Chinese and Indian people who were inches away from buying their first car may now have to allocate more of their would-be disposable income on food and other necessities.

OPEC seems to stand firm on not increasing production to ease prices. (Many people argue if they could up output if they even wanted to, but I won't comment on that). However, if OPEC wants a market to sell its oil ten, twenty, or fifty years from now, it should be more concerned with keeping oil cheap. Finally, fully-electric cars are on the roads (Telsa makes a sportscar, General Motors (GM) is releasing the mass-marketed Volt within a few years), and it looks like they'll be powered by newly contracted wind farms and solar plants. (All right, that's a bit of a stretch, but alternative energy facilities are quickly being built.)

Another energy policy change that may soon occur is the opening up of the U.S. Eastern Continental shelf, which has been off-limits to oil exploration and drilling. The U.S. may couple growth in alternatives with domestically-produced crude filling the important niches. Real measures are finally being taken to counteract the rising cost of energy.

In my opinion, it's time for something to give. A minor policy change, the closing of the so-called "Enron Loophole" (which allowed the buying of commodities on multiple exchanges once the limit on one was met), may have signaled a willingness for lawmakers to win votes by changing laws. The United States is currently warehousing over 700 million barrels of crude in the Strategic Petroleum Reserve. If one million barrels (or less) were released per day, any real supply/demand issue would be completely negated and crude futures would plummet.

Increasing margin requirements would take some speculative money out of the market, but the ETFs are purchasing their contracts with cash. Though bulls argue that crude has much farther to run, the increase past $100 really hasn't been backed by much tangible, actionable facts, and as tidbits of information like the driving statistic surface, this oil bubble may deflate.

Comments

[Greg Pinelli:]

A bubble in the investment universe is an irrational bidding war over assets that are typically sold on future dreams and/or status. Oil would seem to hardly fill the bill...aside from water it is likely the most essential ingredient in any description of developing or developed society. Food, housing, jobs and health..everything is tied to oil and gas.
The vision of demand destruction in the US significantly undermining the cost of crude is very outdated..although certainly a reasonable step beyond the crank "financial" writer William Engdahl..who..now keep a straight face..actually believes in abiotic oil...the stuff literally is "made anew" and everyone be happy!
Oil could correct...perhaps even to $100 or a little below...one never can be certain of China..or whether India will have great internal problems and demand will dry up...
But..the phenomenon we're experiencing is not a bubble....it's incredible utility and scarcity means it is going to be rationed in the market by those who have what's left...the Saudis..the Russians, for instance.
We are not talking about would boxes with a patch of pathetic lawn for people who barely could make it as renters..oil IS blood.

2008 May 28 09:34 AM

[yank:]

For all those US-centric people out there let me gently point out that although gasoline demand in the US is down 0.7% in 2008, emerging market demand (China, India, etc.) is UP 3.7% year-to-date. So much for the bashers of the "decoupling" argument. Unless you "suspend" the rules of mathematics, the net effect of the above is an INCREASE of 3% in gasoline demand. As for the "alternative energy" argument we are at least 10-15 years away from any meaningful or significant contribution from that technology.
I won't even point out the dreadful news about oil supply; Nigeria's oil production has declined 25% in the last 2 years, Mexico's production decline almost as steep, and the North Sea fields dramatically declining. Add to this the fact that Russia's production this year has dropped for the first time in over a decade and anyone can see we have a supply/demand problem. Deal with it.

2008 May 28 10:03 AM

[ETF STER:]

Yank,
Just to clarify your argument, you used the 3.7% China increase and the .7% U.S. decrease as equal usage.
.7% U.S. decrease is how many barrels?
3.7% Chinese increase is how many barrels. Please use these percentages in the proper context.

Thank you

2008 May 28 11:06 AM

[whidbey:]

Wishful thinking is a disease. The author has no more information, or interpretative powers than anyone else. The facts are also a little different. The short run elasticity of demand for fuel is usually overcome by the inconvenience of not consuming. The substitutes can not replace gas except at the price of huge capital investments (recall we are short capital). Finally, I worry about peak oil and inflation induced destruction of demand That could spell a very long slow down. Your analysis is selective and unbalanced.

2008 May 28 11:11 AM

[User 28329:]

Well what about all the countries that subsidize gasoline for their people. Eventually as prices increase there is going to be growing financial strain and they are going to have raise the price of oil and yes China is one of those nations. They are manipulating the markets by taking money made elsewhere to keep gas cheap. Cant go on forever

2008 May 28 12:22 PM

[time_for_re...:]

Michael Masters presentation:

hsgac.senate.gov/publi...

You can also read the article on Barron’s if you have access:

online.barrons.com/art...

2008 May 28 01:42 PM

[time_for_re...:]

If you guys think that this is just a supply and demand issue then simply imposing equal trading requirements on everyone shouldn't have any real impact on the price of the commodity. Let's see! Lobby your congressmen to change trading requirements so that everyone plays by the same rules. Teh commodities markets were created for farmers and corporations to hedge their exposure for their input materials. Make the traders abide by the same guidelines they live by and let's see what happens.

2008 May 28 01:49 PM

[jjason:]

Read the article by Phil Davis on SA. Phil shows how the nymex futures market in oil is speculation and manipulation by many entities. The Futures Commodities Trading Commission, by law, is supposed to protect us consumers from prices that are outrageous. The FCTC has not been doing their job. Phil gives a link to the Congressional Report done in 2002 or 2003 that explains it all.

Those of you who trade in oil futures (speculators) and roll over the monthly contracts are ripping me and other US citizens off. I am fed up with it and I will call my Congressman and tell him to make it necessary for someone trading oil futures in the US markets to take delivery of the oil.

Also, raising the margin requirements will help correct this injustice.

Again, read Phil Davis's article and complain to your Us. Senators and Congressman. By the way, Senator Joe Liberman's name is on the report I mentioned.

2008 May 28 04:11 PM

[Greg Pinelli:]

As a matter of fact...futures traders in oil are often trusts and PTPs hedging their exposure to a dramatic decline..Now..the level of this article is typical of Alpha and many of its contributors..juvenile... have recently been "warned" by Alpha not to be too critical..Garbage!!
When people print their views and analysis..and money is on the line I don't give a damn about their feelings or self-esteem....are you listening David Bui and Kathy Lien???
If Alpha isn't going to carefully monitor these lame and misleading self-promoting picture posers then the Georealist will!!
Oil is NOT a bubble..it most definitely is a supply issue and I STRONGLY RECOMMEND that those who can handle reality go to the Energy Bulletin and start investigating the massive amount of vital info concerning Peak Oil...and I believe, Peak Nat Gas....
My best wishes to all real investors on this site..I will continue to provide the MOST CRITICAL AND INFORMED COMMENTARY on the swill that often passes thru here!!

2008 May 28 09:58 PM

[Stephen Fra...:]

I have no agenda.

2008 May 28 11:32 PM

[coolhand49:]

Georealist --> I agree with your views, for others a good read is Dr. Stephen Leebs "The coming financial crisis" Fundamentally - oil will go to a minimum of $200 a barrel, and our poorly prepared society will suffer greatly.

Getting ahead of this issue is where our Fed Gov has fallen very short, but then again - consumers have demanded vehicles to satisfy their "Needs" with cheap oil - industry followed suit - who was really interested in high mpg diesel vehicles? Only the kooks. Having traveled a bit - I personally would have liked to export the the US from Europe some of their smaller diesel vehicles, but the cost model didn't work.

What many folks do not realize is the the cost of diesel is what the underlying driver of inflation is - only the cost of gas is in focus.

The free market pricing is forcing change and will continue - I submit that a 50 cent a gallon tax on gas, with a decline of 40 cents a gallon on diesel would be a great move right now in reducing inflationary pressures. Whatever is left over needs to go into funding multiple alternative energy programs; nuclear, coal gasification, Wind, Solar.

CH

2008 May 29 09:27 AM

[User 154465:]

Utter BS, there is no way that oil will ever go down below a $100 again. Too much growing demand and the world has reached its maximum production capacity and we are now on the back end of the production curve.

Anther reason for the big price increase is the falling US dollar. To much government surplus plus too many wars with no end insight.

2008 May 29 09:54 AM

[Indyphil:]

What we must remember is that the Price MUST rise until supply matches demand. The demand destruction was neccessary to avoid inventory falling to zero. Its all well and good to point that demand has fallen slighty but the price has doubled in a year, but that misses the overall point. I think this article is helpful by pointing out the in-elasticity of demand, and the long lag times, but ultimatley the demand will need to fall more - and more and more - GLOBALLY to maintian current prices.

I expect the market is taking a breather on this news of demand destruction but will continue to rise as developing countries keep moving. When the Chindia demand stops rising (maybe when they quit subsidizing the stuff) thats when you can call a ceiling.

ETF STER - you are right to point out the % argument.
China consumes over 7mbpd. The 3rd highest behind Japan and USA - they may have surpassed Japan by now these are rough numbers based on 07 figures.

USA consumes about 12mbd, so China's 3.7% increase on a 7mbpd rate, washes away a 0.7% decrease on a 12mbpd habit.

You get the idea. Chindia is in charge now. Their tax policy (or subsidies) are in the driving seat.

2008 May 29 10:02 AM

[A:]

jjason and others - Phil is a moron on the point of speculation in oil - his article that you refer to are the musings of someone who doesn't know a thing about the oil market - if you're going to read that article, MAKE SURE you read ALL OF the discussion that follows - his theories in the article are totally and completely debunked.

In fact here's the link - go for it.

seekingalpha.com/artic...

2008 May 29 10:40 AM

[mee too:]

Our legislature is not smart enough to understand supply and demand, they are too interested in getting re-elected. First we need to change that b4 anything else will be changed.

2008 May 29 04:14 PM

[Paul Killinger:]

That's exactly correct. Fortunately, $4 a gallon gas has finally awakened our fellow citizens. New polls show 2/3 of Americans want the U.S. to drill for oil and gas onshore, offshore and in ANWR. And 90% won't pay even a nickel for the junk sciences of CO2 recapture and carbon sequestration. This will lead to more affordable energy supplies and an end to the oil price bubble.

2008 May 30 08:18 AM

[cynic69:]

Big oil is still buying off the lawmakers. There is no hope for the future.

Stephen - Your article is junk!

2008 May 30 09:48 PM