Oil: If It Looks Like a Bubble...

The clamor over whether “speculators” are driving oil’s parabolic run-up has become almost deafening, with the number of Congressional hearings on the subject reaching 40 this week and the price of oil dominating the nightly news. For every market analyst making the case for a speculative frenzy, the media have found an industry expert to argue that high oil prices are justified by the underlying supply–demand imbalance and weak dollar. If this sounds familiar, it might be because the scenario looked quite similar when the housing bubble came to a head.

Way back in 2005 when the Philadelphia Housing Index peaked. . .no, make that 2006 when it took a major hit. . .er, wait. . .2007 when it fell 50% from its January high - the National Association of Realtors and the National Association of Homebuilders still refused to admit that current home prices were unsustainable.

The real estate bubble was due partly to low mortgage rates, partly to speculation, and mostly to buyers’ fear that if they didn’t buy now, they’d have to pay more later - but it took months of housing declines before the “experts” would admit that things weren’t exactly hunky-dory.

click to enlarge image

Yet the future was crystal-clear to anyone looking at the chart above. The Japanese stock market in the late 1980s (black line) defined modern bubblology, and the tech bubble (blue line) carved out a paragon of the hyperbolic spike. By the time real estate (green) had traced the same vertiginous ascent, the writing was on the wall.

Now the price chart for oil (red) is looking eerily familiar. Ignore the fact that oil appears to be peaking at the same level as its predecessors - each plot is scaled to the vertical dimension of the chart - but note the rate of ascent over the past year. That vertical wall is the scarlet ‘B’ that flashes “bubble” in ten-foot neon lights.

One of the most credible arguments against the speculation theory comes from Daniel Yergen, “one of the nation’s best-known energy experts,” according to the New York Times. A Times article Thursday focusing on Mr. Yergen’s expected testimony before Congress summarizes his position as follows:

As the ninth hearing of the month gets under way on Wednesday ... Daniel Yergin, is expected to tell Congress that the focus on speculation is largely misguided.

Mr. Yergin will join numerous other energy experts who have declared that the rise in oil prices can be explained by basic economic factors, such as the limited growth in supplies in recent years, a weakening dollar, a global surge in energy demand and a string of production disruptions in countries like Nigeria.

Buy wait—there’s more:

Mr. Yergin said the market is relentlessly bidding up oil prices in response to deep-seated fears that the growth in demand will keep outpacing the growth in oil supplies in coming years.

“There is a shortage psychology in the financial markets and that is reflected in the price of oil,” Mr. Yergin said in the interview. “You are seeing a lot of people who have never invested in commodities who are now piling into the market. But calling it speculation is way too simplistic.”

Notice that Yergin doesn’t just overlook the bubbly nature of current oil prices—he actually confirms it, with phrases like “deep-seated fears” and “shortage psychology in the financial markets.” And he doesn’t even touch on forces like the automotive manufacturers’ fixed-price gasoline offers, which must be pumping a huge amount of money (temporarily) into the futures market as these companies hedge their incentives.

But it’s two additional developments that put us over the top. For contrarians, there’s the premier of the cable-TV reality show Black Gold. And for the politically focused, there’s the Republicans’ no-holds-barred drive for legislation permitting oil drilling in previously prohibited off-shore locations, including the Arctic National Wildlife Refuge—heedless of the fact that it would take ten years to have any impact, and that this impact would be minuscule.

Granted, there’s no way to know when the oil bubble will burst. Also granted that the fundamentals do support a certain price that’s above where consumers would like it to be. And yes, the dollar’s weakness is reflected in the price of oil. Unlike the Nikkei, tech, and housing, however, this bubble is likely to deflate only partly, before resuming its climb until alternatives displace oil as our primary energy sources

Disclosure: Author holds a position in United States Oil Fund (USO).

Comments

[fatcat]

About 30 yrs ago,a similar set of circumstances was underway..Oil was high,some commodities were up and all the brokers were pushing the wildcat drillers(Cramer?)and every other energy scheme imaginable.There were ads for gas saving devices and even pills you could put in your tank!

Point is,I've still got some of those worthless stock certificates to show for energy exuberant times.Oil will not go back to $30 a barrel,but this runup will soon be a memory,IMHO..

[Jerbear]

Although oil is clearly behaving like a bubble the article does not discuss one difference between oil and housing and other bubbles.

Oil may have a limited supply, housing does not. Demand for housing can all but disappear but oil is a necessary commodity to run the country. This supply demand scenario may drive oil higher than anyone expects and rather than the bubble popping it may just level out.

Are the housing bubble and dot com bubble good comparisons to oil?

Is this posting just another contrarian indicator?

Any one have any thoughts?

[jcordes]

So the Saudi's agreed to add 200,000 barrels and American demand has dropped. Brazil has uncovered vast, albeit difficult to retrieve, supplies offshore. Drillers and rig companies are ginning as never before and recession threatens to actually reduce demand with airlines cancelling schedules and public transit seeing all time ridership highs, yet the price of oil continues to set all time records.
Meanwhile CNBC never misses an opportunity to state that it's not a speculators bubble but genuine supply issues. No doubt the long term peak oil theory is true but the short term, mid term thesis is debunked. So what will prick the bubble? Only Congress can have an impact now. Of course they have done little besides cesation in adding to the strategic reserve, which is near an all time capacity high anyway, and purchasing additional reserves would seem counter intuitive at the current price levels. Will they act before inflationary oil wrecks what's left of the economy?
My guess is yes. The battle over off-shore drilling, Anwar, extending green energy incentives, regulating oil futures trading, (requireing higher margin percentage), and actually releasing supplies from the strategic reserves represent the arsenal of measures that could and should be utilized. Yet nothing happens, unless you call endless hearings effictive energy legislation. Now Congress will recess until after the July 4th holiday, leaving the real possibility to $150 oil during the interim, and further market equity losses into panic territory.
What's the hold-up? Why is Congress so inept and frozen in inaction? Partisanship of course. But the upcoming shock of the next week may actually shake the tree and begin to end the speculative cycle in oil futures trading. It's not hard to imagine Congress will make the grand compromise and agree to off-shore leases opening, renew the green energy incentives and pass some modified measure that cools off futures trading with higher margin requirements. They might even release supplies from the strategic reserves. Don't look for capitulation on Anwar, but in comparison to offshore leases, this is not that significant. Recovery and production lag time is similar anyway.
So look for a dismal week with market calamity followed by legislation in July. The grand compromise that will finally pop the bubble. When the selling panic begins, the 30% froth in oil prices will finally dissapear. Get thee to the seculars and the shippers or if you must, hang with the oil service companies. The next chapter is written, barring the big unforseen.

[you_can_call_me_Al]

Given that oil bulls are relying so heavily on the demand/supply arguments, shouldn't there be more commentary on the indications of declining demand?

Three years ago the world, and Americans in particular, wasted a lot of gasoline (popularity of the SUV anyone?). Now SUV sales are in the dumps, mass transit systems are much more heavily used, airlines are cutting flights, and summer gas consumption in the U.S. has declined for the first time since... ever? Demand is going down because of the run up in prices. Prices must therefore come down. ...Duh.

Why isn't anybody talking about this?

[kildonan]

Yes I will agree that oil prices are starting to affect consumption in the Western world and will also have increasing impact in all countries if they continue to increase or stay at these levels.

However US consumption of oil is 20 -25% of total world demand/production, and we must continue to reduce either by increasing fuel efficiencies, use of alternative fuels (such as natural gas, nuclear, wind, solar, etc. Otherwise the increase in consumption of energy in the emerging areas (Chindia, Brazil, etc) will not be offset by either the fall in Western worlds's demand or OPEC/Saudi's attempts to increase production.

Oil prices are a global commodity and prices here are determined by the world-at-large, although as the biggest consumer, the USA must one day take seriously it's stake in reducing consumption. The decision by US leaders to do so, will have significant impact on the huge transfer of wealth to and from producer countries (OPEC etc.) and consumer countries (North America, Europe, China).

The mega-billion dollar question is whether any of the US leadership is listening and whether they have the stomach to take the needed steps to educate and truly lead the American population of the importance of reducing their consumption. The USA can only produce 25% of what they consume, so our ability to shift the Supply/Demand basis for the oil price is regrettably limited to the consumption/demand side of the equation.

[kildonan]

Also I want to add that the increasing focus on speculation, oil company profits, etc, all tend to blur the more important issues facing us.

[gigem77]

Well Al, demand in the rest of the world is rising. OPEC is using more as their economies grow. Russia, China and India are all increasing their consumption of oil. Diesel imports to China during the first 5 months of '08 increased 916%. Did you know that the US exports several million barrels of diesel every month?

Then we could talk about declining supply. When the Saudis announced that they would supply an additional 200k bpd of their sour crude, Nigeria announced another dust up that took more than that off the market, but their loss was in light sweet crude. The headline price is always for light sweet, not the sour/heavy types that comprise the remaining OPEC spare capacity. Mexico is cutting exports to the U.S. as their Cantarell field declines rapidly. Venezuela is shopping their oil to the far east rather than sell it to us.

Then we could talk about the currency problem. "In the two years between January 2006 and January 2008, dollar oil prices rose by 46 per cent but in euro terms they increased by only 17 per cent. " tinyurl.com/2pbwwy

The rest of the world isn't experiencing the same level of price shock as the U.S. because their currencies are stronger. Prices therefore can go even higher...

[logicalthought]

According to the Energy Information Administration, until recently the U.S. had been consuming around 58 million gallons per day of kerosene-type jet fuel (i.e., exclusive of JP4, which I guess is what the military uses). If U.S. airlines are averaging 10% capacity cuts, this would be a reduction of around 6 million gallons a day (and perhaps even more, as the "capacity cuts" don't account for the fact that it's the least efficient planes that are getting taken out of service).

6 million gallons equals around 143,000 barrels. If there are 4 gallons of jet fuel that are refined out of a 42-gallon barrel of oil, roughly 10% of each barrel goes for jet fuel. So, although it would take roughly 1.43 million barrels of oil to generate 143,000 barrels of jet fuel, 90% of those barrels are used to refine other products (gasoline, etc.). So, as an oil "pure-play", this airline capacity reduction should amount to reduced demand of approximately 140,000 oil barrels a day.

U.S. gasoline consumption had been averaging around 3.4 billion gallons/year, which equals around 9.3 million barrels/day. If about half of each barrel of oil goes to refine gasoline, the oil "pure play" for gasoline consumption had been running around 4.7 million barrels/day. If U.S. "miles driven" are now down 2.5%, that's a demand reduction of around 118,000 barrels of oil a day.

So, combined reduced U.S. demand for gasoline and jet fuel should now be running around 258,000 barrels of oil a day. If we roughly double this for the rest of the western world (which is probably a reasonable assumption), we get current "demand destruction" of around 500,000 barrels of oil day in the West.

Meanwhile, the number of cars and trucks in China is estimated to be growing at 7 million/year. If each one of those drives 15,000 miles at 25 miles/gallon, you get 600 gallons/year of consumption per vehicle, which equals 4.2 billion gallons/year which equals 11.5 million gallons/day which is around 274,000 barrels/day of additional Chinese gasoline consumption. As around half of each barrel of oil is refined into gasoline, this translates into around 137,000 barrels/day of growing oil demand for the new vehicles in China. (I'm simplifying this somewhat by not dividing this consumption into "gasoline vs. diesel".) If we double this for the rest of the "emerging world" (i.e., India, etc.), you have around 274,000 barrels/day of "emerging world" additional oil demand for motor fuel. Add in another 50,000 barrels/day for increased emerging world motor scooter sales and jet fuel demand (admittedly, a somewhat arbitrary number), and you've got 324,000 barrels/day this year of additional emerging world oil demand, vs. 500,000 barrels/day of Western world "demand destruction".

Thus, I don't know what the fundamental price of oil should be, but whatever that figure is, shouldn't it be a hell of lot lower than the amount to which it has recently escalated? So, excluding "market psychology" and "oil as an inflation hedge" buyers, what (if anything) might I be missing here?

[GORILLA800]

Its not a bubble you jackass.Supply and demand.Plain and simple.Will the price ever come down some?Sure,but dont expect it to last very long.Do the research and quit pointing the finger at everyone.

[buyitcheap]

10 years ago, drillers were trying to open up Anwar and various other postage stamp size spots to get domestic oil supplies. Liberals were against it then, and now they say it'll take 10 more years to have any EFFECT? what you're after is impacting the futures pricing, drill now, and you will begin to put a ceiling in on rising prices. Further, let drilling commence everywhere. Long term this is a perfectly rational direction to go in while the private sector, not government nor environmentalists, create better more efficient ways to deliver energy.

Our lack of energy strategy/policy is an abomination. We should be pushing nuclear and electric cars, efficient autonomous power generation a la solar in germany. Finally, focus on the consumption not by changing the thermostat, but by better insulating homes. I heated a house on 4 cords of wood in Northern Vermont and it was entirely due to solid insulation.

[Ishortyou]

you bring down oil comsumption with other technology in a heart beat, unfortunately we are too lazy to research it unless the gas is more than 5 dollars a gallon.

[Artie D]

The solution to busting the oil price bubble is simple. Drop the margin ratio allowance for speculators. The allowable margin ratio when buying crude oil futures for crude oil is 7 to 1 compared to a margin ratio of 2 to 1 for stock investors. Just drop the margin ratio on oil commodities to 2 to 1, matching the stock ratio, and the available funds used by speculators will plumet and so will the price of oil.

[Artie D]

The solution to busting the oil price bubble is simple. Drop the margin ratio allowance for speculators. The allowable margin ratio when buying crude oil futures for crude oil is 7 to 1 compared to a margin ratio of 2 to 1 for stock investors. Just drop the margin ratio on oil commodities to 2 to 1, matching the stock ratio, and the available funds used by speculators will plumet and so will the price of oil.

[CBrown1818]

If the oil prices are being driven by supply and demand it is very important to remember to take both factors into account and to consider them globally. It seems like a lot of people doing supply/demand analysis are simply forgetting that it is a combination of things. Yes US demand has dropped a shocking 1% (sarcasm) while oil prices have doubled. But don't forget that emerging economies are growing AND global supply has been dropping simultaneously. This is an obvious and somewhat pointless observation, but it seems like many analysts are getting stuck on only what is happening in the US or only what is happening to demand. Not all of it.

[footballtaxman]

Arnie, your view is too simplistic. Markets outside of the US would reap the rewards of trading as they will not in concert increase their margin requirements. We are in a global marketplace.

[footballtaxman]

Artie D, sorry for the name messup in my first email.

[DaveinHackensack]

Gigem77's comments above are astute.

[Jane]

The real estate bubble was due in large part to mortgage fraud as well as this country's repeated insane belief that the govt and big business will not steer consumers wrong. The FBI had reported by at least 2006 that almost all the mortgage fraud was being done BY the industry, too. And yet, despite some token investigations and arrests, and some fines, we'll do it all over again in a few years. Well most of us will. There are still people who know BS when they see it.

[Tmalan]

The current pricing is not sustainable, whether it is a bubble or not. It is already having an impact globally. I have not heard of one country that uses oil where their inflation is going down. Having all the other food commodities in the same boat will have an impact on the developing world's ability to afford the high cost of oil and dampen the demand at least for now. The balance curve has swung way to far in the other direction.

The thing that concerns me is how much control oil producers seem to have right now. Please tell me if I am incorrect in deriving my conclusion, but it seems to me if you have so many future contracts bought ahead of time, you have a fairly accurate picture of how much you need to produce to meet those contracts. Then adding the fact you can get real time physical demand information allows you to control the supply. This allows the producer to have tighter inventories thus fueling the "tight supply" psychology. I think that there is evidence of this when Libya made their announcement that they may cut production. Why would they do that if there is such a high demand? Retaliation or not, you would not do this if you were making major $$ on what you are producing. Seems more logical to suck money from America if the demand was there. The only conclusion is to keep inventories from building so that they can keep prices from falling.

[mangolfer]

Saudi's, Oil Companies, and a speculator all say it's due to speculation.
Read for yourselves:

hsgac.senate.gov/publi...

[johny6677]

I've seen many comments like "US dollar dropped and people hedged against that buying oil". Clearly this does not make much sense. If US dollar drops against the Euro, it makes more sense to go long the Euro, not buy oil. IMHO it is mostly speculation that drives the price of oil higher. The demand/supply balance has little to do with the current prices. I've read somewhere that 70% of the oil futures contracts are held by people that have no real intention of actually buying the oil, they're only in for the ride. They have limited imagination and seem to like the peak oil concept. The solution should be simple: make all futures contracts settle for the underlying when they expire. All speculators will either become oil importers and consumers, or will flee. I believe that price of oil is way too important for us to allow a minority to profit whilst the rest of the world will suffer. I do have some serious doubts about the Congress doing this - lets not forget that they are only humans, and humans can be corrupt...

[john s. gordon]

quacks like a bubble, waddles like a bubble, has webbed feet like a bubble, undsoweiter...
> jack

[oil baron]

By 2020, according to both national and international projections the world will consume 120mmbopd. By 2020 there will be nearly 1 billion cars on the world's roads up from 450 million today.
Trying to micro-analyze the current runup of oil prices is an exercise in futility. The future is bleak for oil consuming nations, especially ours. There will be no viable alternative energy either commercially viable nor economically feasible except nuclear within the next 12 years. The "Three Mile Island" syndrome will prevent the building of nuclear facilities for many years to come.
Within the next 25 years there will be armed conflicts over dwindling oil reserves. I predict that the US, China, Russia and the EU will take over the middle east oil fields either peacefully or through armed conflicts. The middle eastern Opec nations have had a good run but they will not be able to control the destiny of the major economic and militarily powerful countries much longer.

[Jimbo]

I have to agree with and support jerbear. The "bubble" in real estate and the "bubble" in oil are two entirely different creatures. Relatively speaking, the demand for housing is much more elastic than the demand for petroleum. Petroleum is getting evermore costly and difficult to find and produce. When Congress authorized drilling the ANWAR in 1996, Bill Clinton vetoed it saying, in effect, that it would be TEN years before we saw the oil. Well, it is now TWELVE years later and we are paying more than $4.00 for a gallon of gas. There may be a component of speculation in oil but there is a much bigger component of stupidity and ignorance in both parties in congress. It has been asserted that if ANWAR were the size of a basketball court, the required drilling are would be the size of a business calling card. I have no way of testing this assertion. In my more paranoid moments, I suspect that most Democrats, some Republicans, and most enviros WANT a severe fuel crisis in the U.S. so they can impose a utopian world where we depend on animals, sailboats, walking and bicycling for transportation.(I rode a bicycle to and from work 3 to 5 days a week for the last 19 years of my working career BTW). One question for the above Utopians: what to we do with the methane gas and horse manure. (Yes,Yes! Grow tomatoes!)

[jcordes]

The following report illustrates why the US is not paying attention. We (the Congress) once again failed to pass the renewable energy incentives, still held hostage to opening Anwar and the Bush energy policy. The new tech industry of the 21st century is being captured by our competitors while we dither and emphasise one wobbly leg on the stool. www.energy-base.org/fi...