Oil: This Isn't a Bubble

by: Ron Haruni posted on: June 09, 2008 | about stocks: DBO / OIL / UCR / USL / USO    
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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.

This article has 13 comments! Add yours below...

Ron Haruni

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This article has 13 comments:

  •  
    Ernie
    Montague
    Jun 09 01:28 PM
    All very true, just don't be surprised when this summer's gas consumption is down 5% from last year, with further decreases coming.
  •  
    Eric Fox
    Jun 09 01:44 PM
    My Website
    Where do you get your data from? The link below shows a one million barrel a day deficit in supply, not 2 million for 2007. This deficit was met by a slight draw down in inventories of 800K barrels per day, leaving ending world inventories at 3.5 billion barrels a day. For 2008, it is estimated that supply and demand will be equal - hardly justifying a $138 a barrel oil cost.


    tonto.eia.doe.gov/cfap...
  •  
    junkyarddog
    Jun 09 02:30 PM
    I don't know where the author gets the data either, but one huge mistake: the assumption that the data is static AND that the data is reliable.

    So, the supply / demand ratio will not change? Did it change 12% in two days to justify the rally last week? Most important: what makes the author think the world can afford $140 or more a barrel? People will consume less, subsidized fuel will die. India can do only so much spending 22 billion dollars a year in gas subsidies at CURRENT prices. How long will China last doing the same? Not long if the world cuts down on discretionary spending and the whole world goes into recession / stagflation. Then WHO, please tell me, will be able to pay $140+ for oil? How can this be sustainable in the long run? And the author simply says as a matter of fact: it's not a bubble. What about some facts to back this claim? Supply / demand is not cutting it.


  •  
    Larry M.
    Jun 09 03:29 PM
    The Only Bottle Neck in Oil Production is in the Willingness to Tap into Alaska's 200 year Supply of Oil just Waiting to be Tapped ...... which of Course would make the USA Totally Energy Independent of ALL Foreigh Sources of Energy.

    The US needs to Develop better Scrubbers for the Refinery Processes and then start to Get that Easy Oil to the Surface in Alaska.

    None of this is difficult to accomplish .... but it will Piss off the Middle East .. IF.. we simply use Alaskan Oil instead of Imported Oil.

    Now is the Time to do it and do it Swiftly. Tap Alaskan Oil ...... Big Time !!!!

    Declair Our Independence from Foreign Oil !!!
  •  
    blah-blah
    Jun 09 03:31 PM
    Friday's massive short covering put to rest the argument that commodities are longer a supply/demand market.
  •  
    Ernie
    Montague
    Jun 09 07:42 PM
    200 year supply in Alaska... Pardon me while I bust out laughing. Try 200 DAY.
  •  
    Commodity
    Bubble
    Proponent
    Jun 10 04:43 AM
    Your data sucks dude...

    omrpublic.iea.org/

    IEA said that in the most recent quarter, OECD supplies fell by approximately 8 million barrels with a 53.4 day cover. Inventory levels are ABOVE AVERAGE.

    If we had this structural shortage that Wall Street and this guy thinks actually exists (like a 1.7 million barrel/day shortfall), our inventory levels would be down nearly 30-60 million barrels/month. Sorry man, nice try.
  •  
    paulk8756
    Jun 10 09:36 AM

    I beg to differ, today's oil prices are higher than they will be, say, ten years from now. The economic principals of demand diminution and substitution are aleady at work. Prices have risen to the point this time where, barring a complete collapse (...in either the price of oil or the world economy), alternatives have become too attractive to ignore. And that doesn't take into account new oil discoveries, which are just now beginning to come on stream.
  •  
    paulk8756
    Jun 10 10:41 AM
    Ernie,

    Regardless of how much oil there is in Alaska, don't underestimate the ability of the "Know Nothings" in the Congress to permanently muck up our nation's economy with their "Green Shackles" ideas. As we look to the future, basic economics and a reading of history tells us what doesn't work.

    Here's a partial list: The self-imposed boycott of our own nation's oil and gas resources, the on-going regulatory ban against the development of additional nuclear power facilities, oil shale and clean coal technologies, new taxes on domestic oil and gas production, investigating the commodities markets, proposing lawsuits against nationalized oil companies, raiding the SPR, new taxes on domestic energy production and various other price fixing schemes, and the $5 TRILLION in new taxes resulting from their latest cap and trade charade.

    As it is now, it will take years for our economy to recover from these combined assaults. The longer we wait to clean up this mess (...which we will, I might add!), the more dollars we'll send overseas that could have been used to improve our environment, instead.
  •  
    cal48koho
    Jun 10 11:19 AM
    Excellent post of the fundamentals, the microcephaliic deniers notwithstanding. The politicians and the unwashed rabble will just have to work through the 5 stages of grief, you know 1. denial 2.anger. bargaining, etc. Then maybe we can come up with a strategy on how to transition to some sort of society that will still function under an increasingly expensive energy scenario. We need a discussion on the core issues of transportation, food, housing and stop wasting time on trying to sustain the suburbs and the long car commuting model. I suspect the day may come when we will be drilling AK, Miami Beach and the Potomac River but by then oil will be way too precious to waste on car and truck transportation. If you think oil has gone up, try looking at other energy sources. My coal and natural gas positions have been blowing my oil positions out of the water. Times are a changin' out there folks. Suburbia accessed by your Suburban(great name eh?) is in it's death throes and please let's stop wasting time bitchin about $4 gas. IN 4 or 5 years when the SHTF, we had better be well along on an intelligent strategy of using energy parsimoniously. There is no going back to the 50's. Get over it.Think about cutting energy demand as fast as you can and becoming more self reliant. A large part of our country will soon be on the move as the distant suburbs depopulate their Mcmansions. And stop trashing Ron for his attempts at analysis that you don't like and can't understand.
  •  
    john s.
    gordon
    Jun 10 01:27 PM
    the natural market for alaska oil is asia, always has been, not the lower 48.
    > jack
  •  
    William
    Vernisie
    Jun 10 02:09 PM
    New oil discoveries... such a pretty sounding phrase. The problem is, those new discoveries will most likely be small folds of oil between two sheets of rock. Hard to drill and harder to extract. We currently use very sophisticated methods of locating oil and we are still coming up empty-handed. All the easy oil is being pumped. With oil being at the $140 level all oil deposits, including shale oil and tar sands are looking mighty feasible these days. It's only the technology that holds us back. Also, the gov't. will have to release land it now doesn't permit exploration on. We have no other alternative oil "discoveries"...
  •  
    Waiting for
    action
    Jun 18 01:44 PM
    Looks like the issue will be divided again... The Republicans on the get more product and use supply and demand to solve it and the Democrats on the other - tax the "Big Oil" companies and do nothing about supply - hit the consumer in the pants for being too wasteful and the best - wait another 100 years to act on this issue...

    Get real... Windfall Profits Tax did not work last time and it will not work now. The only thing that will work is working hard to produce what we have and find an alternative to the black stuff!!

    Our elected officials need to be held accountable for this mess... We should demand that they use every means possible to let the world know, especially the other producers, that we the largest consumer will not be held hostage by them. Open up the flood gates and start drilling and refining some US oil from any place we have reserves....

    Another thing... Why can Hugo Chavez and Castro drill 50 miles off Florida and we can't?

    Who is better at making sure we do not create an environmental problem? The US producers that we can control or Chavez/Castro who we have not been able too???????

    I live in Texas and there are oil wells everywhere. Refineries just outside of Houston and all along the coast... I suggest that Texas become it's own country again, as it has the right to do, and tell all the blue bloods on the east cost to stick it and pay the price....

    And... Who cares if Asia is the easiest market for OUR oil in Alaska... We own it so we keep it!!! Spend the money to get it home where we need it.
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