Is Oil a Bubble? Part Two

In Part One of “The Oil Bubble,”  we looked at the current price appreciation in crude prices and tried to determine if it whether or not it was sustainable. We compared the recent run-up to other various commodities, all of which have corrected sharply, and compared the multi-year advance to other bubbles like the tech bubble of the late 90s and the more recent housing bubble. Our conclusion is that oil is indeed a bubble, but that it is difficult to determine what inning of the game we are in, to use a mixed metaphor.

In this missive, we are going to look at the causes of the sharp ascent in oil prices. The media has run countless stories about who is to blame, and Congress has even hauled in big oil executives to point the finger and demand answers from them. However, as we will discuss in a bit, Congress should really take a more introspective look if they want concrete answers.

Economics 101 tells us that the rise in the price of a good is purely a function of supply and demand, and specifically the intersection where the two reach equilibrium. As such, if demand rises while supply is held constant, prices need to rise for the market to remain at equilibrium. So let’s look at both supply and demand, both of which have played a role in the oil bubble.

First, most observers consider it a foregone conclusion that demand has skyrocketed, due to the large number of new consumers that have emerged in countries like China and India. However, the recent run-up in oil prices has far outpaced anything seen on the demand side.

Global oil consumption grew +2% in the first quarter of this year, while production increased +2.5%. Therefore, there is not an outsized amount of demand, which is physically being consumed. That means that a large amount of demand is coming from speculators, who drive the futures prices of oil higher purely for investment reasons.

Institutional investors, battered by the bear market in 200-02, turned to a new so-called asset class in the form of commodities. Investment demand came from all sorts of institutions, from hedge funds, endowments, pension funds, Sovereign wealth funds, and exchange-traded funds. In the first quarter of 2008 alone, global investments in commodity indexes rose $40 billion (+28% yr/yr) to $185 billion, which, according to Citigroup, was a larger gain then all of 2007.

Hedge fund manager Michael Masters testified before Congress last week that while China’s demand for oil has increased by 920 million barrels in the past five years, demand for petroleum index futures has increased by 848 million barrels. This means the effect of speculators in just about as large at all the growth from China. This is amazing.

Therefore, it is clear that demand is rising, but it’s not just from growth in emerging market economies. That part of the equation is relatively easy to quantify. The wildcard and the one which I believe has more to do with the recent parabolic spike we’ve seen in crude prices, is from the new “Index Speculators” as Mr. Masters has called them, or institutional investors.

In Part three, I will delve into the supply side of the equation, and investigate how Congress is really trying to deflect blame by casting the big oil companies as the enemy.

Comments

[GORILLA800]

Bubbles and speculators.Keep telling yourself that.Maybe that will solve the worlds energy problems.lol

[Roger H]

From teh article:

"demand for petroleum index futures has increased by 848 million barrels."


One thing I am wondering is:

This oil that speculators are buying - it has to be stored somewhere - correct? After the futures contract closes, the oil that is produced has to go somewhere. Where is all this black goop? Who is hording this stuff? What do they do with it?

Thanks.

[Ernie Montague]

Speculators don't buy oil, they buy contracts to deliver oil. A very different thing. The oil is not stored anywhere, the contract is simply a promise to deliver at a certain price. And with a 7% margin requirement, a possible huge debacle if oil prices go up or down 20%...

As far as the price, supply and demand theory in Econ 1 is just that, theory. It does not entertain the reality that water is a fairly renewable resource, and oil is not. So if you jigger supply and demand to include FUTURE supply, the sky is the limit. They ain't making oil anymore. Any sophmore in petroleum science knows that.

[paa]

Roger H., the answer to your question is, "There is no black goop." That was Masters's point: the 848 million barrels exist only on paper contracts. Because index speculators roll their contracts every month, the paper is never converted to black goop, just longer term contracts that have, so far, been increasing in price. In the oil biz, that's called contango. This is a good time to remember Stein's law: if something can not go on forever, it will stop.

[ship shape and bristol fashion]

I wonder what the big deal is. Why is it not OK to invest in oil? When I think WTI will appreciate in price, it is and should be perfectly legal!

Everything money can buy is a potential investment: Stocks, bonds, currencies, commodities, real estate, stamps, old handguns...

Every driver may feel free to hedge his risk by buying the USO or a similar product.

[Sophisse]

As if a single quarter delta of 2% vs 2.5% proves anything - ordinary fluctuations or heck a rounding error could do that. Or perhaps the price increases caused demand to dip a smidge - without the price increases, perhaps the world would have tried to burn 3% i.e. more than is available.

I'm sure there are speculators around - when prices of anything shoot up, speculators will be there. Perhaps that means oil will drop some from current prices. But is anyone suggesting it will fall to $10?

[ChuckE]

Listen folks, as long as people in my neck of the woods insist on driving their monster trucks three blocks to purchase a latte then we got us an oil boom. Invest accordingly.

[Alex Filonov]

"Economics 101 tells us that the rise in the price of a good is purely a function of supply and demand"

Sure. But we have mostly market of futures, not the market of oil. So in reality the price is defined by supply and demand of oil futures, not of the commodity itself.

[Paulo]

Ernie M. -- whenever I have heard, 'they ain't making it no more' (usually combined with you had better hurry and buy because of increasing demand caused by demographics or whatever), and whether this is applied to land or whatever, things have never ended well for the last ones to join the party.

[SweetHomeKilla]

<i>Bubbles and speculators.Keep telling yourself that.</i>

Why are you Peak Oil/Chindia taking over the world/This Time it's Different fanboys so afraid of anyone calling the oil price a bubble? Just STFU and leverage up already! No one's going to talk the bubble down and you're not going to talk it up either.

[Ernie Montague]

Paulo:

I am not suggesting anyone buy oil for investment. I am pointing out that the long term trend for oil is not likely to be an oversupply, given the increasing population and consumption. Any investment is risky. A recession for a year could drive oil down to $65 a barrel, and it could stay there for a decade. I am simply pointing out that supply and demand economic voodoo on a finite resource is simplistic.

[tuj]

Ok, so now speculators are bad? Sure they are taking overwhelming long positions, but if the true market fundamentals are such that this is a bubble, then it will pop and they'll all be crushed just like in housing. So what's the need to drive them out of the market? If anything, other speculators should come in on the other side now and start shorting if there is any truth to this 'bubble'.

If there is truth that the supply-demand is tight, then the speculators are doing everyone a favor by moving prices higher now, which should accelerate changes in demand.

I'm baffled why so many free-market advocates want to tinker with the oil market. If you believe in the market, then it should correct itself, right?

[riverpirate]

Just think for a second about the actual dynamics faced by market participants:

1. Refiner. He needs to buy oil in the cash market and/or futures market. He knows that the crude costs $45 on average to pump. Why would he be willing to pay $135 for that barrel? Because he has to. Refining margins are pathetic right now due to this, but refiners have a lot of leeway to pass on their costs due to the public's general accetance of volitile gas prices. In short, the refiner does not care about the price he pays unless it will cause him to operate at a loss -- which will only happen if somehow demand for gasoline fails to slacken AND his ability to pass on costs is constrained. Barring an act of congress this will not happen.

2. Index Speculators. They bet that oil will be scarce and are willing to pay a premium -- any price really -- to have a piece of the action. They are willing to pay any price because no matter what that price is, they belive it will be higher due to 'supply and demand' dynamics in the future.

2. The producers. The producers SELL their crude to refiners in both the cash and futures markets. Many people dismiss the oil runup as a bubble because "cash and futures markets' operate independently and there is no delivery of paper barrels. I belive this is a TRAGICALLY flawed argument. Why? If I'm a producer who's average cost to deliver a barrell is $45, I would be willing to sell my oil for $50 any day, right? Easy money. However, why would I sell my oil on the cash market (which is detached from the futures market) for $50 when I could wait 1 month and get the future's price, which will make me literally 17X more profit!

The truth is while many people say that CASH and FUTUTES markets operate independently, they hold each other hostage because there would be an arbitrage opportunity if the prices diverged too much. What would that arbitrage opportunity be? Hoarding oil! This isn't rocket science really. Until refiners operate at a loss or are no longer able to pass on the cost of their oil inputs, they have no real incentive to challenge the price they are paying in the cash market. Additionally, the cash market participants must charge a similar price to the futures price, because if it were wildly different they could make good money by simply holding on to it for a later date. Since refiners need oil to keep doing business, they pay the cash price, which is tied to the futures price by an arbitrage mechanism.

Guess what, the futures price is set by a steady deluge of "hot money" from every corner of the market right now. From hedge funds, to index funds, to armchair specs, they all want a piece of the action. In order to get sellers for their INSATIABLE demand for contracts they are running up the bids: it is the only way they can attract parties to the other sides of the contracts.

What makes matters worse, all the other world grades are held hostage to the WTI price. Why? Because if the WTI price is $135 the other grades could be arbitraged if their price did not rise to a level that reflected $135 minus deminished refining potential. The whole of the world's oil is indeed being priced by a deluge of demand for futures contracts by non-commercial players, and I've yet to hear a compelling reason why these dynamics are not what is exactly what is taking place.

[E. Gjertsen II]

As the recent turmoil in the credit markets have clearly outlined, the investment world has many more avenues at its disposal in creating "virtual positions." No one can truly know the notional size of commodity bets placed amongst us around the globe. What we do know is that when the unwinding occurs, it will create interesting times.

[hsbgill]

The article confirms my thoughts regarding energy generally and it would be nice to know what inning we are in.

[anaconda]

Regrettably, Mr. kahn overstates the bubble. The price most likely will drop, but down to $100 a barrel. That's not a bubble, that's a correction, or "bump." There simply is too much pent up demand in the market (demand is restrained at this price, but will jump at lower prices). Maginal addition to supply, which balances the supply - demand equation is from deepwater, deep-drilling, which costs about $70 a barrel to "lift" during production onto the market.

To Ernie Montague: The supply of petroleum is not constrained from a physical aspect. There is lots of oil to discover and produce, expensive, yes, but will be produced at the right price.

Most of this oil is offshore, as to your comment, "They ain't making oil anymore. Any sophmore in petroleum science knows that."

That may be true. But there is a lot more oil than is currently generally believed. And, sorry, but sophmores in petroleum science don't know squat, because, oil geologists wrap themselves in dogma.

There is hard science, lots of it, that says oil is not due to algae, but you wouldn't learn that in petroleum science class.

Check out today's Oil Is Mastery blog post and subsequent comment on George F. Becker. Interesting science that contradicts "fossil" theory, which has never been rebutted by "fossil" theorists.

[yuman]

Would someone deconfuse me on the effect of speculators?
Since they buy/sell contracts and most of those have a life of a month, the effect of speculators must be limited to this lifespan. At the end of the contract's life, the buyer must sell and the seller buy, canceling out their effect. Therefore, the speculators only serve to facilitate the market during that lifespan.
The continued rise in oil price beyond a month due to speculation can only be explained with continued inflow of speculative funds that support the uptrend.
Then, the question is why is there so much net inflow that bet on the rising oil? Why don't the speculators bet on dropping oil?
At $130, there are still plenty of buyers of oil, who obviously accept the price as reasonable. If price does not destroy demand, why is this a bubble? Or, is this a demand bubble, rather than a price one?

[pachanguero]

More witch hunting crap. Man you really should study markets instead of looking to blame Bush or the "speculators"... Poor quality stuff for this site.

[mpkirby]

I think the "blame the speculators" crowd is missing the point.

While the "future" price of oil might be high due to speculation, ultimately when the speculators roll the contracts forward, they sell their soon to expire contracts to someone that actually wants to get the oil.

If it is a speculative bubble, that oil ends up being purchased at a loss to the speculator. Or a speculator actually takes delivery of the oil and stores it, pushing up oil inventories.

Inventories are not up, and there isn't a significant loss being taken by speculators.

Therefore, we can assume the demand is real at this price.

Mike

[john s. gordon]

future supply of oil - is unknowable at this time since we have not begun to tap the potential of liquid transportation fuels from coal via (if you want high yields) catalytic hydroliquefaction via 2-stage processing. question is - who will step forward & provide the front-end investment? the bush/cheney administration won't do it because they receive their orders from the houston oil corporations. the h.o.c. won't do it because they are too busy making money from the current speculative excess.
> jack

[Jack Yetiv]

Who here thinks OPEC will let oil go back to $100?

In other words, who think that if oil corrects "too much" OPEC will NOT cut production by a million barrells or more to push oil back up to at least $110 or $120?

Remember, in inflation-adjusted dollars, $100 oil is no more expensive that oil at its peak 30 years ago. Plus take into account the falling dollar, and OPEC can legitimately argue it's not really getting much more goods and services in exchange for for its oil (priced in dollars) than it was 30 years ago.

Jack

[paulk8756]

The day oil dropped $4+ a barrel last week coincided with the release of a Gallup poll revealing 2/3 of Americans want the U.S. to drill for more oil and gas offshore, onshore and in ANWR. In fact, 90% of us oppose carbon sequestration and cap and trade, and only 20% blame the oil companies and OPEC for high gas prices.

Think that $4 drop in oil prices was a coincidence? Or are the traders on Wall Street simply watching the "know nothings" in Congress and taking their cues from Capitol Hill? We'll find out this coming week... Cap and trade (Warner-Lieberman) comes up in the Senate, and the Market will react accordingly.

This will once again confirm that the market is trading on the supply and demand for oil, not speculation. Congress has mandated 85% of our offshore oil and gas resources out of bounds to oil and gas exploration (...except to Cuba and China, believe it our not, who are drilling there as we speak).

So watch the debate, and watch energy prices. The two will continue to correlate exactly. Proof again that our energy crisis has been manufactured by our politicians. It will be interesting (...and enjoyable!) to see what happens, now that the Senate is aware the public has caught on to them.

[Xenon]

According to T. Boone Pickins and the IEA the world has only produced 85 million barrels of oil per day since 2005. So what is the source of his data that the production of oil increased by 2.5 %?

[CLH]

Jack---You are right that most of oils rise has been the weak dollar--not a shortage of oil. However, look at the 1980s when the dollar strengthened, oil crashed. OPEC is a toothless outfit of greedy bastards who will NEVER cut back as was shown in the 1980s.

[oil baron]

By 2012 the world will consume in excess of 91mmbopd. By 2030 the world will consume 130mmbopd.
Worldwide production capacity stands at just under 89mmbopd.
The most optimistic capacity predictions rise to 93mmbopd by 2015.
Several professional oil analysts already predict Saudia Arabian production is maxxed out and in decline. Indonesia recently dropped out of OPEC due to the drop of production under 1mmbopd.
85% of the known world oil reserves are in countries not friendly to the United States.
I don't know how much affect speculators in the futures markets have on oil prices but I do know that as time passes oil prices will continue to rise and ultimately to well over $200 a barrel.
It all comes down to supply and demand and to try to analyze oil prices on a micro rather than a macro basis is an exercise in futility.
We have no energy policy in this country but we do have an anti-energy policy. I blame Congress for not have the balls to stand up to the likes of the Sierra Club and the treehuggers.
Our only salvation is to get over the "Three Mile Island" syndrome and start the approval process to begin building at least 20 nuclear plants.

[Dr. No]

Masters point was that we have a commodity bubble due to an influx of significant financial resources looking for high returns. In fact global assets under management have increased by 50% from 2000 to 2006. What is that money investing in after equities and real estate have become unattractive and debt is not providing 30% returns? Art? Cars? Clothes! Cotton!

To that end a myopic oil view isn't helpful. The latest commodity bubble being cotton contracts should make people wonder where all of the sudden the cotton demand is coming from. Why are farmers in the South not able to get contracts? Did all of a sudden a new fashion trend explode in going cotton pumping demand? Let me just make up a couple of urban legends:
* Cotton is in higher demand as more countries move out of poperty and desire higher value clothing with cotton.
* China and India has increased the average wardrobe size and now they need to fill it.
* The prolongation of the Iraq war has increased the demand for white tees by our forces.
* China is planning to build the largest Cotton shield for the olympics and that has dramatically added to cotton demand.
* As the polar caps melt, the increase in population in those regions will not wear fur but cotton to deal with the summer heat.

Anybody else wanna have a go ?

[Jack Yetiv]

CLH, how about a $10,000 bet with me that before oil touches $90, somebody from OPEC or the oil minister of some OPEC or major oil producer (eg, Russia) announces that they are going to cut production, which then results in oil never actually reaching $90?

Jack

[User 202964]

Response to River Pirate ("the cash and futures market hold each other hostage):

The 2 markets do have independence. The cash market is the only one where real oil is traded and it reflects immediate demand and supply. The futures market attempts to anticipate where the cash market is going to be. A flow of money into the futures market favouring higher prices would create losses to the speculator if they bet wrong when settlement date approached.

But does bidding up the futures price influence the cash/spot market? Will producers hoard oil to achieve a higher price later in the year as the futures price suggests?

Probably not. Every market has sellers who need cash now so there will always be sellers to match buyers. At the same time, hoarding creates inventory that must later be sold and is negative for futures pricing. So hoarding can have no long term effect on pricing. The idea that inventories or ability to supply is increasing will destroy the higher futures pricing. The incentive to hoard will end. If there is a link between the futures and the cash market, it is not lead by money flow into the market, but by very real considerations of supply and demand.

[Forgot]

I don't think you can compare Tech & Housing with Oil. As the world population grows the need for energy will grow along with it. I don't think oil is now begin over pumped. Therefore I think it will be a long time before oil will ever go down in cost.

[rainman]

oil is now regarded as the nature substitute/exit to the weakening dollar, while there isn't any main stream currency, not even EURO could be able to replace.

Oil is the only hard currency!

[Reinko]

When you study the Masters pdf file, after some easy calculations you see there is about 37.2% of index investor money in it the oil markets.

And when you realize oil production is not elastic because it is running at almost maximum capacity, barrel prices could be 37.2% lower compared to what we have now.

Dr No from above says it all: There is still much to much money into the system because every dollar of profit on the oil markets generate many dollars of damage on a global scale.

[MNSL]

I partly agree with your article.

Definitely we see speculation in the oil market in addition to demand factor. Everybody into commodity now. We know what happened to all types of bubbles in the history. Very soon oil bubble will burst.

[AverageJoe]

I keep listening to people claim that the US gov is repsonsible. Fisrt of all th eUS has no oil we are nothing more than a customer just like China and al the other develpoing countries. The difference is that there are many more cusotmers than there were 10 years ago.

As far as supply goes. If oil wasn't over $100, the oil companies would nit have made these large new discoveries, drilling 10 miles underwater is soemwaht costly.

And finally we still many shall I say not to friendly people trying to blow up pipelines and tankers.

Oil will not ever go under 80 again until we find a replacment for the combustible engine.

I am now seeing peopel adjust to higher oil prices. What did they do they stopped spending like glutonous spoiled consumers that they are.

They walk, they take public transportaiton and finally the soccer moms have stopped tooling around in theire big A$$ SUV's talking on the phone all day.

Just my thoughts form Boston MA

[farhad]

The price of oil has increased by more than %160 since Jan 2007. Did we have an increase in demand of %160 or did we see a decrease in supplies of %160 during this time? We are in a huge bubble and it will be very messy when it bursts.

[ship shape and bristol fashion]

High oil prices are a blessing in disguise:

1. It makes new reserves recoverable.

2. It forces economies around the world to be more efficient in their
use of energy.

3. Oil north of a hundred bucks a barrel is a great opportunity particularly
for the United States. US oil service and offshore drilling companies are
the undisputed leader in the world market.

4. For Ford, GM and Chrysler it means: You either make a technological
leap forward or you go bankrupt.

Wouldn't it be nice if US car makers were leaders in technology for a change?

[ship shape and bristol fashion]

to farhad

where did you get that nonsense, that demand and price have a linear relation?

[green_cheeks]

WELL

[green_cheeks]

My predictions....and these are primarily based on what I refer to as "peaking oil" as opposed to peak oil. My hunch about peaking oil is based on the various view points that I have read or heard from people close to the action including the contrary commentary too. I just don't find the contrary viewpoints to peaking oil to be all that convincing.

The price of oil will continue to ascend it's price at a steady acceleration due to the lack of alternatives for current users/addicts.
Due to the high price of oil and it's direct influence on our economic reality, our spending will shift from wants to needs in a progressively gradual manner(needs being food and shelter (rent, mortgage, and/or comfort).... most of us have no need for new clothes). It will be more important to feel somewhat warm and cozy in the winter and somewhat cool in the summer, at least more important than the pleasure we derive from our eyes and hears and all industries that revolve around them. We will still have the American appetite. I know few people that will sacrifice their favorite carbon input loaded diet for much else, me included with my avocados, California salad greens, coconuts and other tropical fruits. We will no longer be able to have our cake and eat it too, in a sense. There will always be the super rich with the ability to buy whatever they please, but the other 95% of us will be choosing to heat or cool our homes moderately, eat our same or similar diet without a lot of changes. Nothing is as close to a person's heart both literally and figuratively as their stomach. We have had a economy that has serving our neurosis and our needs. Well, when push comes to shove, our neurotic selves give way to the needs of the body.
It thus my belief that our economy could focus on consumer needs for a while and that the next bubble will include all of the industries that are required for the production, supply, and distribution of these items, thus oil, ag, natural gas, nuclear, wind, solar, rail delivery as opposed to truck, etc. Some could argue that we have seen a bubble already forming in these industries but then again, it is not like people are pulling ALL of their money out of Apple at this point to invest in our more immediate and basic industries. The market seems to be fairly diversified still, a diversification that resembles the idea that cheap oil will perpetuate into the unknown future.
So I guess my little ramble is this, we have had an economy predicated on cheap oil for a long time and it will correct itself. It is as we have been taking out a loan that is now due. The way it will be paid off is through a more subsistence like lifestyle. It is also my belief that commodities will be the most stable currency. The people that get in early are going to see those investments grow exponentially, even if one starts today.
This is the way Warren Buffet thinks. Ken Heebner, the other, virtually unknown Wall Street maverick (currently on the cover of Fortunre) also is on this track. Both these investors are basic needs investors and virtually no tech to boot.
One other thing I would like to address is the "it is different this time" theme that sometime props up. Well, it actually could be different this time. We now have 6 billion people fighting for dwindling resources.