Oil: This Isn't a Bubble

Includes: DBO, OIL, USL, USO
by: Ron Haruni

A few weeks ago the crisis commodity switched from oil to rice. Now it’s back to oil again and logically so, one would argue. After all, crude futures surged almost 8.5% on Friday, touching for the first time ever $138.54 per barrel.

The $10.75 (June 6) price gain for the day was the biggest gain in dollar terms ever and the largest on a percentage basis since June 1996. It was also the single largest one-day price rise in Nymex crude contract history.

Oil prices printing record highs, just when oil seemed poised for a price regression, prompted many to blame speculators for the rise in crude prices.

Those who see speculators as the culprits are basing their assumptions mainly on the premise that: extended periods of rising oil prices have allowed speculators to begin taking long positions in anticipation of coming shortages.

They also point out that oil prices have risen by as much as 97% in 12 months and 165% in 3 years - suggesting that something more than just supply and demand are driving oil prices to their current historic record levels.

Another aspect being alluded to is that the trouble in the CDO market and rapidly rising commodity prices, as the flow of funds quickens into areas that are less risky and promise higher returns than mortgage backed securities, such as highly liquid commodity derivatives, strengthens the case for the speculation hypothesis even more.

Only this week, billionaire investor George Soros told the Financial Times that while he feels the commodities markets, in general - are a bubble in the making, a crash there is not imminent. He further stated that the prices of oil have been driven much more so by institutional oil futures investment surges.

So, it stands to reason that these assumptions, from an analytical perspective are based on reasonable and perhaps valid points. However, first - we should make an important distinction in relation to the bubble topic: There is no bubble in oil prices.

It is already a known phenomena - when stock markets move towards the top of their bubbles, it’s on rising optimism, whereas when commodities move towards the same peaks, it’s on rising fear, whether it is fear of inflation, fear of shortages (as is the case with oil) or fear of deficits. To assert that oil prices are in a bubble, you would need to prove that oil costs are also in a bubble;simply put - that is not the case. The point is that it’s harder for a bubble to develop in oil than in the shares of internet firms, say, or in housing, where the supply of the asset is finite.

Secondly, the relentless increase in oil demand is clearly outstripping expansion in supply. Crude oil demand for example, continues to grow by more than 1% per annum with no sign that this will be brought to a halt despite the oil price flirting with $140 level.

Currently, oil demand stands at 86.4 million barrels per day, while supply is at 85 million. Resulting in a deficit demand saturation of 1.64 million barrels of oil on per day basis. If this specification persists, oil price increases become the norm since directly related with economic activity. Furthermore, we have not had an increase in supply coming to market (excluding the insignificant 300,000 barrels per day of Saudi output several weeks ago) in the past three years despite more than 165 percent increase in the price of oil.

It is important to remember that most oil price spikes, shocks are the direct result of reductions in supply arising from wars, embargoes, or geopolitical uncertainty tied to developments in important oil-producing regions. However, the latest rise in oil prices - including the 40% devaluation of the greenback during the past twelve months which has contributed towards the surge in the price of all dollar-denominated commodities including crude oil - appears to be stemming, importantly, from fast-growing Asian countries.

Oil is the lifeblood of the functioning of global economies since it is an important energy source for most industrialized or industrializing countries. As long as demand remains strong while supply scarcity exists, prices are likely to continue up-trending. The bottom line is: oil prices are up because we are running into actual limits on commodity production.

While there will be inevitable corrections, absent a widespread economic contraction that greatly reduces demand, oil prices aren’t likely to come down in a meaningful way. Most oil stocks, including the stocks of oil service companies, remain undervalued at current levels.