Oil Prices and the "Bigger Fool" Theory

From Wikipedia:

The bigger fool theory or greater fool theory (also called survivor investing), is the belief held by one who makes a questionable investment, with the assumption that they will be able to sell it later to "a bigger fool.” In other words, buying something not because you believe that it is worth the price, but rather because you believe that you will be able to sell it to some one else for an even higher price.[1]

In my honest opinion, I think that the oil markets, describable as a bubble, can now also be filed into the category of "bigger fool" investment vehicles.

Just this weekend, Barron's interviewed Arjun N. Murti, a top energy analyst at Goldman Sachs (GS). In the interview, Murti said that we are now in the "later stages" of a "super spike," a dramatic short-term price increase where, he thinks, we will see a barrel of oil hit $150 - $200.

Murti argues that the price really is driven by supply, unlike the speculation-driven theories of other analysts. However, I took away too other noteworthy nuggets of information:

On the front page of Barron's website (I'm not sure about actual magazine layout), the subtitle of the article throws out a $5.75/gallon gasoline quote. However, in the article, Murti more conservatively states:

 Oil at $150 to $200 a barrel would imply between $4 and $5.75 a gallon.

Though not incorrect, Barron's focus on the maximum estimate is exemplary of the current fanaticism in the oil market. Ignore the reasonable or low-end expectations, but rather, shout the highest ones from the mountaintops.

Even more surprising and important was Murti's long term estimate, which does not get mentioned on the front page. In the article, Murti says:

 Our long-term oil forecast looking out 20 years is [for crude] to fall back to $75 a barrel, or some lower number.

This sentence perfectly states why I think that current oil prices are now reflecting a bubble, or now even a bigger-fool type of market. Murti, who did correctly call $100+ (and now even more expensive) oil, is forecasting that the era of $150 or $200 oil will not last long. Though not too many people could short oil today on the thesis that it will eventually, within five, ten, or 20 years, halve in price, the forecast of an eventually-lower figure shows that speculation does influence, if not control, the current market.

It seems as though investors aren't concerned if oil will be $120 in December or $100 in two years.  What's important to them appears to be the prospect of selling their U.S.Oil Fund ETF (USO) (which allows any investor with a brokerage account to essentially buy oil futures) for a couple bucks more in a week or a month.

What started the two-day, $15+ rally in oil was an update price forecast from Morgan Stanley. Stating that Asia will consumer a greater share of Middle Eastern exports, they predicted that oil would hit $150/barrel by July 4th. I am admittedly not an expert, but that prediction, made midweek when oil was as low as $122/barrel, seems to me like MS was a little presumptuous - how could that small change merit a $30, or 25%, price increase?

Oil rallied through the end of the week, gaining $10 on Friday, on that report and a "weaker dollar." Yes, the dollar did drop as much as a few percent against the Euro, but why does a 1-2% drop in exchange rates trigger a 7% increase in the price of a related commodity? (Also, that same day, disappointing employment numbers were released. Normally, I'd expect a economically-bearish news nugget like that to move oil prices downward.)

On this hype, I attempted to short USO on Friday, but was denied as a significant percentage of my portfolio is currently short First Solar (FSLR)and Salesforce.com (CRM). When I wrote this post, oil was down about $3, but as the previous contraction from about $135 to $122 showed us, all it will take for a nice surge in prices is another bullish report from experts.

My thesis remains that the price of oil resembles that of a bubble, or a "bigger-fool" type of market. In hindsight, I'm glad that I'm not short, because I don't want to be holding the bag if oil does appreciate another 10, 20, or 30%, as many individuals and experts are forecasting (or speculating). However, I agree with Murti's long-term thesis; expensive oil is making alternatives very viable, if not much cheaper compared to hydrocarbon solutions.

Maybe $120 or $150 oil will eventually reflect the supply-demand equilibrium, but I don't think that that time is now. I think that the best option is to just sit on the sidelines; maybe you'll miss out on some fast money, but someone is bound to end up holding the bag when rationality defeats speculation.

Comments

[Gary Lucido:]

The speculation story makes no sense: www.investingminds.com...

Furthermore, you say " Our long-term oil forecast looking out 20 years is [for crude] to fall back to $75 a barrel, or some lower number.

This sentence perfectly states why I think that current oil prices are now reflecting a bubble, or now even a bigger-fool type of market."

There is not a necessary connection between the two. You can believe that oil today should be $135 and will be much lower in the future. It all depends upon your view of supply and demand over time. Oil is highly inelastic in the short run but very elastic in the long run.

2008 Jun 10 08:27 AM

[DONE_SONZ:]

If oil cant last at $150 - $200,how long would it stay at your price of $75 when people up their demand like wild fire?The direction remains up and the problem remains.Oil runs the world.Get used to it already.

2008 Jun 10 09:23 AM

[GH:]

Gary Lucido: Your (currently front-page) blog post makes a lot of sense but unfortunately is built on a false premise:
"But speculation does not drive up the price of a commodity like oil."

Go read about Amaranth. The oil price run-up is exactly the same thing as Amaranth did with natural gas. There are just more and bigger players, that's all.

Legislation *is* the answer, for the simple reason that commodities were not cornerable until Goldman-Sachs and Morgan Stanley and a few helpers used Phil Gramm's disabling of the existing regulatory structure (aka "The Enron Loophole") to create ICE, thereby circumventing the Commodity Futures Trading Commission. (Gramm's wife, who ran the CFTC, simultaneously helped disable its regulatory capability. Either one would have removed regulation from its role to provide rules whereby the commodities markets can't be cornered. Without rules and referees to enforce them, games involving wealth quickly go as this one has.

You're just not aware of the latest info, Gary. Go watch the testimony to the Senate Commerce Committee last Tuesday, on CSPan's website.

2008 Jun 10 02:45 PM

[john s. gordon:]

deregulation (or refusal to enforce existing regulations) enabled the enron fiasco & enabled speculation to generate 138.00 oil.
> jack

2008 Jun 11 09:07 AM

[ArtfulDodger:]

The questions everyone interested in whether there is a shortage of oil or whether the price is being pumped should attempt to answer are these:

If there is a shortage of oil, why are there no lines at the pumps? Why are there no stations closing down because they have no product?

It seems to me that if you can afford to pay, you can buy all the product you need --- anywhere in the world!

I've seen the pump game played many times before (in almost every sector), and the recent run up in oil fits the pattern exactly.

That being true, however, doesn't mean that the price can't go higher. It does mean, though, that when it comes down it's going to come down hard and fast.

Almost every one writing and commenting on this blog seems to think you must either be short or long at all times.

But this seems to me a time to sit back and wait. Say oil spikes on up to $150 a barrel, how much have you missed making from $133?

Irrespective of the regnant momentum theory, why risk buying after such a speedy run up?

Take a break. It's summer.

Rebeldog

2008 Jun 11 11:21 AM

[Dr. No:]

It is all about supply and demand - supply and demand of paper on oil and other commodities, demand for ever higher returns on assets invested.
The Gramm loophole and his wife being at the CFTC is quite amazing. Too bad that Spitzer got hooked. We should have Enron 2.0. Where are Sabanes and Oxley these days ??

2008 Jun 11 12:02 PM

[Paul Killinger:]

Yeah, oil prices are "bubbling" alright. And they'll continue to until new SUPPLIES come on stream. (...SUPPLY AND DEMAND, remember?). Right now our best prospects for this occurring are from Canada and Brazil, since we've have a Congressionally imposed regulatory boycott against exploring domestically for our own oil.

As for those of you who believe there's some sort of conspiracy going on in the markets, this bears repeating: It's not speculating when you're betting on a SURE THING!

And, as regards Congressional testimony, you should know that NO ONE testifies before Congress unless they're invited by a committee CHAIRMAN (...who's a Liberal, since they have majorities in both the Senate and House).

Speaking of which, they can castigate "Big" oil all they want to. The majors control less than 15% of the world's oil supply, and their 8% profit is in line with other U.S. manufacturers. (...Indeed, if that's such a good idea, why not subpoena Putin and the Arabs as grill them on TV for awhile?)

I would expect to see "light bulbs" going on here, except I know better. Yes, the Green Menace can repeal the laws of supply and demand, berate our own energy producers, convene one-sided testimony, chase imagined speculators, and sue OPEC. They can even dance in the halls of Congress if they want to.

But they can't control the price of gasoline (...unless they ration the stuff... don't laugh, that's probably next!) no matter what they do. Until significant new supplies or alternative sources come on the market, gas prices are only going to go UP, UP, and UP!

2008 Jun 11 12:55 PM

[whisperonth...:]

I work for a manufacturer, small though they may be, and it is true that the markup is at least 8%, and often as much as 100% - whatever the market will pay, that's what the price is. But the US is not the one increasing demand. Our demand is dropping while China and India (and others) are increasing their demand. So demand overall is not decreasing. Supply will have to increase to meet demand or we will have to find other ways - ethanol is not really an option when it affects food prices as it does. In the meantime, I'm riding the oil train, increasing my profits, and watching for the next big game.

2008 Jun 11 07:18 PM

[Steven Ward:]

A legitimate case can be made for oil to drop as Murti states and as Murti states it won't happen for over a decade or even two decades. However, no one should short anything in the "short" term.

2008 Jun 11 07:19 PM

[surgcare:]

I wish people like the author would stop trying to influence the market by writing this non-sense . The reason oil is expensive and will be that way for a long time is not only because theres a demand imbalance , but overall oil is cheaper than anything else( Electric cars will burn more energy due to inefficiency , and therefore cost more ) . The other very important reason ,people like the author can't seem to comprehend , is that it cost more and more to drill and deliver oil .If people want oil they will have to pay more and more because it cost more and more to produce . Another concept these "bubbleheads " can't understand is that if oil comes down to 75 dollars a barrel , there won't be any oil because no one will drill and produce the stuff . Hence , there is no bubble only bubbleheads .

2008 Jun 11 07:56 PM

[jjason:]

Steven, Thanks. You are right.

The same folks are spouting B/S again.

Thanks GH, there is speculation going on and Phil Graham and his wife did exactly what you said they did. With the OPEC monopoly, oil executives who don't care, speculators who refuse to learn what is being said about "the enron loophole" and others who think "paper oil" or hoarding oil is OK, we have to continue to ask Congress to fix the problem by changing the laws.

I hope the oil speculators lose a lot of money just like the speculators in housing. You SOB's who are cheating the public should be put in jail.

2008 Jun 14 11:09 AM