The Oil Bubble Will Meet the Same Fate as Tech, Housing

Over the last ten years the S&P 500 has returned a meager 2.88%. Why? Because in the long run the market doesn’t like bubbles. We’re now in the third wave of bubble euphoria and we’re hearing the same underlying message that we heard during the first two, just in different terms. During the dot-com era we watched tech fly to P/E multiples of 200 and above. When fund mangers were questioned about investing in such companies back in 1999, they collectively responded by saying times had changed. Lofty valuations became the new norm-until they crashed that is. The Nasdaq (QQQQ) still isn’t even half of what it was in 2000. The market’s punishment of the dot-com bubble has lasted for seven years.

Real estate investment shifted into bubble status due to low interest rates and easy lending practices advocated by the Greenspan Federal Reserve. Back in 2005 it was difficult to find anyone who didn’t want to jump into real estate. Flipping homes was the new trend for amateurs. Unfortunately it’s always the last guys in who get burned by a bubble. Those developers are being suffocated from the holding costs on their sinking investments. After watching home prices double and triple, nationwide home valuations have plunged since 2006 with more yet to come. Homebuilders (XHB) and financials (XLF) have been crushed by the bursting real estate bubble and it will likely take years before these stocks regain prior highs.

Now it’s oil (USO) that's bubbling. Two weeks ago oil prices reached a 600% increase since the bull market began. The oil bulls are using the same arguments that we heard from tech analysts in 1999 and real estate agents in 2005. They will use any rationale they can find to shift our focus away from the fact that gasoline shortages don’t exist and new oil is plentiful. There are now 53 commodity ETFs and ETNs that have caused average daily volumes to soar from 5 million in 2006 to well over 30 million today. History will repeat itself and the last guys in will get burned. Industry insiders believe that the proper valuation of crude is somewhere between $40-$50 a barrel. When will this bubble burst? Nobody can predict the exact time but the essential elements are in place: the Fed is done cutting interest rates, Bush is waiting on Congress to lift the offshore drilling ban, Congress in considering limits on speculation and high gas prices are decreasing demand.

The conclusion is that we are hearing the same story coming from the oil sector that we have heard in previous bubbles. They will tell you that this time is different, or that the fundamentals have changed - when they really haven’t. The only thing that has changed is sentiment. This bubble will burst just like the last two and it will be ugly for those who have gotten caught up in the hype. Over the next six months investors should average in to a short position in the U.S. Oil Fund (USO). Be suspicious of alternative energy as well. Solar, wind, natural gas, etc... will all fall with oil.

Disclosure: Long DUG

Comments

[goatfarmer]

A very well written and cogent argument. Against the argument that the bubble will burst soon are the facts that US demand no longer dominates the market and demand around the world is buffered by subsidies in many countries. But I agree with the sentiment.

By the way, I made a 60 year crude oil chart today on a log scale and found a nice little channel (big channel actually) with resistance bang on 140 or thereabouts. It will be interesting to see if it is borne out by a top in the coming months.

2008 Jul 18 08:19 AM

[Outtanames999]

We all hope you are right. Where is Greenspan to declare "irrational exuberance" for oil? Well, at least we have you.

But even if this market eventually corrects itself, one has to wonder, why is the cost of oil is so disconnected from the cost of production, refining and distribution, and why is it disconnected from actual supply and demand?

We can see clearly now the supply chain is corrupted when futures market pricing drives retail prices in real time (but of course in the up direction only - prices at the pump somehow never fall as fast as they rose).

Speculators should be free to make whatever speculative bets they like in free markets. However, there is no reason those bets should affect the underlying subject of the bet.

When you bet on the outcome of a sports game in Las Vegas, your bet has no affect on the score of the game (unless there is corruption which of course would be, uh, how should we say, Illegal).

Can you imagine what would happen on the field if the players had a stake in the betting action on the game and the odds were posted on the stadium scoreboard in real time during the game? This is what we have in the oil markets today.

In the same way, speculators should be able to bet in a disconnected way on the future price of just about anything. But their bets should not drive the market or corrupt the supply chain. And this is what we must achieve in the oil markets or we will certainly have more bubbles in the future.

The price of a commodity is a kind of score. And the scorekeeping must not be in the hands of the gamblers in the oil markets any more than it is in the sports betting markets.

Not to mention, this is the age of the Internet, the great disintermediator. Name one industry that has not been disintermediated by the net. Oh, yeah, Oil.

Why can't I buy my own barrels of oil direct from OPEC? Why must I buy through a corrupt, unregulated and disorderly commodity exchange market?

Where is the Amazon and Orbitz of the oil market that puts the customer in control? It sure isn't the commodities market.

As to drilling in Anwar, et al in the U.S., before we go down that path and begin consuming our reserves, we must ask ourselves some very fundamental questions.

So let me ask you this, if you could choose between these outcomes, which would you pick? We run out of oil before the Saudis. The Saudis run out of oil before we do. We both run out at the same time.

Now what do you suppose the odds are that we and the Saudis will both run out of oil at exactly the same time. You got it - that will never happen. So we are left with the other two.

I don't know about you, but if I had the choice, I would rather see the U.S. be the last oil field standing (our children's children and all that), so I'm not that eager to see us start the drilling quite yet. Oh and since we know that the price of oil has nothing to do with supply and demand, all the drilling in the U.S. will do nothing to bring down prices. Sad, but true.

So we are left to other means of ensuring that prices are not corrupted by the markets. Anyone have a plan for that?

2008 Jul 18 08:24 AM

[Echo To All]

I don't know if Oil was as severe of a bubble as you claim because we can not dismiss the fact that supply constraints existed, and demand was really high. There are also obvious macro economic effects that support an elevated Crude price. But, with that said, I was Short Oil via USO puts from 138-145 as the fundamentals drifted from the price of Oil.

Over the past few month we have been seeing a huge demand destruction, lack of physical buyers and emerging markets slowdown, yet Crude kept rising.

We will be able to call oil's awesome move a bubble if...

1. demand destruction continues
2. new supplies come on line to meet future growth demand
3. how quickly the US can adjust to alternative energy vehicles
4. geo-political threats ease

All of which will continue to create downward pressure to oil, and fortunately are in the cards, but we can't call oil tulips just yet.

2008 Jul 18 09:08 AM

[jayjayjay1212]

Very good article.

I don't agree with the 40$ oil statement about industry insiders (Boone Pickens, an insider, sees it at 100$), but still the article is very insightful.

Speculators have an essential role in the oil market, but the so-called index investors (mostly large passive pension funds who look for the diversification benefits of investing in commodities) do not. Index investors do not serve a specific purpose on the market; they only put upward pressure on the price of the barrel that is unfortunately not always corrected by speculators. This has the effect of transfering wealth from net oil importing countries to net exporting countries.

Explanation:

The portfolio of the pension fund that invests in oil will get greater benefits from diversification, but it comes at the expense of its clients (us, individuals) paying significantly more at the pump. Therefore it's actually a very unprofitable and short-sighted strategy by pension funds to invest in oil futures, since their clients lose a lot more than they gain from it!

It would be nice, but unlikely, to see the US government regulate the index investors, and letting speculators do their job.

2008 Jul 18 09:09 AM

[User 228158]

This is one of the best articles I have read on the oil prices. Finally someone pointing out that there is no oil shortage and the bubble will burst. The bubble will burst probably sooner than later once everyone sees what the auto manufactures have in store for next years non-gasoline cars.

2008 Jul 18 09:13 AM

[DONE_SONZ]

Boy,they let anybody post one of these I guess.Oh yeah,oil is over a $100 for no reason other than speculation.How about doing some research and posting something worthwhile.

2008 Jul 18 09:28 AM

[CLH]

Very good article. No its NOT different this time. DUG is a winner.

2008 Jul 18 09:36 AM

[Don Agree]

Today oil spiked up on Nigirian pipeline explosion, By observation and of the oil market swing the last 5 times the market began to retreat there has been a nigiran pipeline explosian. UMMMM lets see is it possible that the nigerans may want to make more money. So they have been conditionted to be a price improver. Do you really think they will disrupt it bad enough to cut their own financial throat.

The last time the oil bulls ran amuck. We did not have an oil man for president. They released millions of barrels from the stockpiles into the market. The price dropped like a rock. Ending the supply vesus demand arguement,

Short selling is not the same as naked shorting. The trouble with the market is nobody sees the rigged game. Goldman sachs oil will go to 200.00 What losses on other investmets are they tying to recoup. So we buy in to every rumor blogger sound bite. Trendy get rich quick deal, Buffet is Buffet because he plays the long game.

HELLO you have a shortage of oil when you have a line around the block at every gas station and you can only buy gas on alternate days based on the odd or even last digit on your license plate.

Yea that reallly has happend puppies. Yes .COM < REAL ESTATE< now OIL has bubbled, Game over. YES SIR history and memory really are an under valued commodity.

Have you ever heard of anybody being able to stampede a herd of Bears. Ah Ha bulls now that is a different animal that does not think about anything but the direction of the stampede.
They don't seem to ask themselves should I be stampeding. Is this real or is it the perception of reality of my own desire.

I can only hope that some of the rules of the game that have been lifed and modified to the detriment of the market are reinsated soon.

Profit is profit it is only greed that makes you want more then enough/ Greed is never pretty.

2008 Jul 18 09:55 AM

[awb]

Jason, you clever boy. You sure have picked the trends. First dot-com, then real estate, now oil. You are not to be fooled.

Question. Why hasn't the global production of oil increased over the past few years as the price has soared? Hmm. Why are all of the OECD producers declining in production? Hmm. Why are the reserve books at the OPEC producers so opaque? Hmm.

No, Jason, this is not a bubble. It is the beginning of the end of fossil fuel as we know it. It has been a very good run this last hundred and thirty some odd years, digging out the cheap stuff and burning it into the atmosphere. But every party must end.

Tell you what. Let's us wager on the chance of $50 oil. Ever again. All in. That way I won't have to keep watching this slow motion nightmare of our global economy unwinding and coming apart.

I can just sit on my beach blowing bubbles.

2008 Jul 18 09:55 AM

[yngalpacinolookslikeme]

I like pretty much all comments herein. outtanames certainly gives a very, very good response and perhaps an excellent question. If I were kidding I'd say listen to ex-Penn professor and philosopher Buckminster Fuller. His answer: photosynthesis. Think about it. Your car, plant, factory would have a photosynthetic power source. Give it H2O and sun and pow wam, you had energy. Realistically, I don't know the answer but I think like in the movie "Man on Fire" with Creasy (Denzel):
Fuentes: A last wish, please, please. Please.
Creasy: Last wish? I wish you had more time.

2008 Jul 18 10:01 AM

[investor88]

Goldman and Matt Simmons' view is that oil prices will be high and likely to go higher in coming years as supplies are tight and increasingly costly to find, unless there are breakthroughs in alternative energy. I think this view still carries weight despite the opposite view expressed by Jason.

2008 Jul 18 10:04 AM

[buyitcheap]

The black swan in this is unstable oil producers - Iran/Africa, etc. A big "blow up" there, pardon the pun, and oil is up $20. I think this is a short term pull back in a rising price channel. It ain't over yet.

2008 Jul 18 10:06 AM

[FeverBuster]

christletoe,

The last report from the EIA on gasoline indicated the opposite from you claim of being at an all time low and on the verge of shortages. Please post a reference for this claim.

Additionally, with oil being at an all time high, inventories have to be managed better to hedge against potential price drops like what we have seen in last few days. The higher the price of oil, the less the demand, and thus the less inventory needed as buffer. As the demand goes back up, so will inventories.

2008 Jul 18 10:16 AM

[Mark McHugh]

I'm noticing a disturbing pattern developing here. The very same people who didn't "get" the housing bubble are screaming bubble in oil.

Guess what? They're sense of direction is as skewed now as it was then.

2008 Jul 18 10:22 AM

[Crapneck]

"They will use any rationale they can find to shift our focus away from the fact that gasoline shortages don’t exist and new oil is plentiful." Please state some facts instead of this general statement "new oil is plentiful." The reason you don't back this up with facts, is because it is not true. The fact is that there have been no major oil producing fields discovered in over 40 years. Many of the fields have reached peak or are on the decline. Many asia countries and other emerging market countries that didin't demand oil in the past, are demanding oil now. Auto sales in June surged in China for example. We may have some short term price declines in oil, but the long term pressure on prices will be upward. The difference between oil and housing and tech is that oil is a limited resource. Please provide more facts to your argument before you just post something that people want to hear so they believe (as evidenced by the posts above) without using data to back up your point.

2008 Jul 18 10:25 AM

[Malkiel]

All of these simpletons in your fan club probably couldn't even find China or India on a map. They probably have no idea of the demographic tsunami buoying up oil--1 billion Indians and 2 Billion Chinese who are becoming automobile owners. The population of the US is 300 million, or 10% of those two countries. Try to imagine the oil used to manufacture and drive A BILLION NEW AUTOMOBILES.

If oil pricing stays flat at its current level for a while that will be a great gift because it will give us time to develop alternative energy technologies. Spending that time drilling new wells off Santa Monica will be beside the point given what will happen to demand elsewhere in the world. And while those other countries will be clever enough to do some of their own alternative energy development, it's unlikely the fruits of their labor will be anything we can just buy at Home Depot to run our homes.

It's time to wake up and smell the coffee and stop being a nation of wishful thinkers who enjoy nothing more than bad-mouthing trends we don't like as "bubbles" that must be superficial and will therefore go away if we close our eyes hard enough...

2008 Jul 18 10:31 AM

[FDRFan]

Allowing the oil speculators to run free and effect a resource that drives almost every aspect of our economy at the same time our economy is taking a beating from the fall of the housing industry is the perfect recipe for the 2nd great depression. We need a President who will step up and take bold moves to push the country and the congress into action. We certainly are not going to find this in Obama or McCain.

2008 Jul 18 10:32 AM

[yngalpacinolookslikeme]

Malkiel, good joke: "Try to imagine the oil used to manufacture and drive A BILLION NEW AUTOMOBILES."
Fyi, unlike probably YOU, there are a chit lot of poor people in these countries that cannot afford an indoor toilet, let alone an "auto" "mobile." Plus, what drives these countries is the unbelievable engine called the "US consumer." If the US consumer stops buying guess what happens to the growth in these 2 countries. Take a wild guess.

2008 Jul 18 10:42 AM

[nebulae]

wishful thinking mr. schwarz and to most people on this post who agree with him!! oil could go another 20 bucks lower to $110 the next 2 weeks, but you know what? - it will soon be back to $140 and keep rising. I'm of the school that oil will hit the $200 mark by next summer. I don't like paying gadzillions at the pump either, but if you want to stay in an investment for the next couple of years, oil is it. it truly won't go on a more permanent decline any sooner than that. notice i said "more permanent decline". it's funny watching cnbc and other financial shows getting their panties wet cuz oil just dropped $15 in a week. get ready $250 oil baby - i'm just sayin.

2008 Jul 18 10:52 AM

[X-terminator]

The total cost of the Iraq war, we as a nation send to the middle east that much money every single year for oil! That my fellow Americans is the reason we should start drilling now and before we run out of this black crap, the alternatives will be in play. Oh, by the way how much of the money we send to the middle east ends up in the hands of our enemies!

2008 Jul 18 11:04 AM