BubbleOmics: Oil's Fair Price Won't Go Down

Includes: OIL, USO
by: Andrew Butter

A bubble is when prices go unnaturally high for a while and then they pop; what happens next is predictable. The recent dynamics of the oil price has followed a classic pattern:

Assuming that the “fundamental” of why people buy oil and how much they are willing (or able) to pay for it didn’t change radically over the past year -- that people still need to drive to work -- and nominal GDP in the world’s biggest customer, which determines how much they have to spend on gasoline, didn’t change much, then regardless of whether you buy the estimate of other than market value, that’s a classic bubble/bust/overshoot/recovery pattern.

If you buy the valuation, then at the top of the "spike" the "correct" price for oil was $68, so when it hit $147 or so that was 116% overpriced.

If the $68 was right,then the trough should have been (1-1/2.16) = 53% underpriced at the bottom.

The pricing model says the "correct" price in early 2009 was $72, so that gets you to $33, which is pretty much on target (+/-1%) if you buy the model -- and if not, well, it’s in the ballpark.

Note: By the "correct price" I am talking about the "Other-Than-Market-Value" worked out loosely using International Valuation Standards to estimate of what the price should be if the market was not in what George Soros calls "disequilibrium".

The model uses nominal GDP and the trailing average 30 Year as inputs; the logic is similar to the model used to predict the S&P bottom +/- 1% and the stock market rally up to within +/- 1% of Dow 10,000.

It’s hard to know if it works for oil because the market is often not really a market (OPEC, wars. embargoes…etc), although the symmetry of the recent bubble bust does add some credibility to that notion.

So why was there a bubble?

There is still a debate raging about what caused the $147 per barrel spike (or classic bubble). Some say it was the hedge funds, some say it was the Saudis holding back to "milk Daisy", some say it was a plot.

My money's on the hedge funds, i.e. a classic naked-credit-fuelled bubble and pop.

And for an encore?

First, it’s highly unlikely prices will go down much, although typically the periodicity of a bust is the same as a bubble (this time about 18 months), so expect oil to head up towards $80 by April. There might be some wiggles on the way and the exact number will depend on where the 30-Year Treasury and nominal GDP of the world's largest "customer" goes.

Then who knows?

Perhaps the hedge funds on Wall Street will get their sticky fingers on some of the TARP and/or TALF money and create another bubble; perhaps there will be a war -- wars are always good for the oil price.

It would be ironic if the boys on Wall Street managed to create another bubble using money from Uncle Sam, which will mean that the long-suffering and supremely tolerant US Taxpayers will end up paying through the nose twice, one shot of $700 billion for TARP and another shot for the increased oil prices.

Don't rule that out -- the "shadow banking system" needs to "earn" its way out of the last hole they dug themselves so that they can continue their essential (socially useless) “support” for the US economy.

But don’t expect the US Government to do anything about it either (like stop people betting naked), or pump out of the strategic oil reserve to teach them a lesson (imagine if they had started selling that at $65 in 2007, then bought back the stuff after all the gamblers had lost their shirts – of course that would probably have meant more bailouts – zero sum). But better to let the US taxpayers pay $500 billion more for their gasoline

If the hedge funds can be persuaded not to create another bubble (locking them up might help), and if the US war machine can be persuaded not to invade some new hapless country or another whose un-elected despots have thumbed their noses at them, then the oil price should bubble along and quite possibly hit $90 by the end of 2010.

The point is it won't go down; the only “unforeseen” events that might happen will send it up.

Disclosure: NO POSITIONS