Is Oil a Bubble?

黄河之水天上来

Is Oil a Bubble? Part One
Oil is now front and center on everyone's radar. Last night, CNBC ran a special tonight about oil, and had a banner running across their ticker titled "America's Oil Crisis." Congress is looking for scapegoats to blame for high oil prices, and is hauling in oil executives to testify, and propsing stupid ideas like a windfall profits tax.
Funny, look at the first chart below of wheat (and the chart for corn looks identical). Looks like wheat and corn have had parabolic moves higher, but I haven't heard any talk of windfall profit taxes on the farmers. Rather, Congress is trying to pass further subsidies for the farmers, who are arguably in the best position of any industry in the country.
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The next two charts show the extreme, straight up moves in other commodities. I have included lead and nickel, but there are several that fit the bill. What I am highlighting is that these parabolic moves higher are never sustainable. And when they eventually run out of steam, they usually succumb to large corrections.
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Given what we have seen in many of the other commodities, take a look at the chart below for oil. Look similar? If I showed you the charts for all of the other commodities, a logical conclusion would be that the trajectory of the upward moves was unsustainable, and susceptible to a sharp pullback.
However, for oil, for some reason, people think that the recent high prices are a sure signal that $150 and then $200 are right around the corner. Now I want to be the first to say that I have no idea how high oil will go. To be honest, I am surprised it ever reached $135.
Unlike stocks, which can shoot to the moon, high oil is self-defeating. As prices skyrocket, it slows economic activity and can bring some forms of transportation to a halt (just look at the news from AMR Corporation (AMR) that it is cancelling flights, and Ford (F) is curtailing production on some of its gas guzzling vehicles). That, in and of itself, would cause a correction in the price of oil (as demand trails off).
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The chart below is from the good folks at Bespoke. It shows the relationship of the current oil bubble to the last 2 big bubbles in tech stocks and then the housing market. This week, the rise in oil eclipsed the mammoth rise in tech stocks in the late 90s. Pretty incredible, huh?
And we know what the end result of those two bubbles were, right? They both ended very badly, especially for folks who got sucked in anywhere near the top. Which brings me to the million dollar question: where is the top?
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No one knows for sure where the top is, and those that tell you they do are simply lying. If you had bailed on tech stocks in 1998, you missed quite a move higher still. If you sold your house in 2004, you left a lot of money on the table. So my hunch is that I want to remain long oil/energy names, although I do not want to chase the recent move higher.
That said, when this bubble bursts, most people won't believe it and will continue to buy on the way down. But history tells us that we should look for those signals as a reason to lock in profits for good, and then simply move to the sidelines.

黄河之水天上来

In Part One of “The Oil Bubble,”  we looked at the current price appreciation in crude prices and tried to determine if it whether or not it was sustainable. We compared the recent run-up to other various commodities, all of which have corrected sharply, and compared the multi-year advance to other bubbles like the tech bubble of the late 90s and the more recent housing bubble. Our conclusion is that oil is indeed a bubble, but that it is difficult to determine what inning of the game we are in, to use a mixed metaphor.

In this missive, we are going to look at the causes of the sharp ascent in oil prices. The media has run countless stories about who is to blame, and Congress has even hauled in big oil executives to point the finger and demand answers from them. However, as we will discuss in a bit, Congress should really take a more introspective look if they want concrete answers.

Economics 101 tells us that the rise in the price of a good is purely a function of supply and demand, and specifically the intersection where the two reach equilibrium. As such, if demand rises while supply is held constant, prices need to rise for the market to remain at equilibrium. So let’s look at both supply and demand, both of which have played a role in the oil bubble.

First, most observers consider it a foregone conclusion that demand has skyrocketed, due to the large number of new consumers that have emerged in countries like China and India. However, the recent run-up in oil prices has far outpaced anything seen on the demand side.

Global oil consumption grew +2% in the first quarter of this year, while production increased +2.5%. Therefore, there is not an outsized amount of demand, which is physically being consumed. That means that a large amount of demand is coming from speculators, who drive the futures prices of oil higher purely for investment reasons.

Institutional investors, battered by the bear market in 200-02, turned to a new so-called asset class in the form of commodities. Investment demand came from all sorts of institutions, from hedge funds, endowments, pension funds, Sovereign wealth funds, and exchange-traded funds. In the first quarter of 2008 alone, global investments in commodity indexes rose $40 billion (+28% yr/yr) to $185 billion, which, according to Citigroup, was a larger gain then all of 2007.

Hedge fund manager Michael Masters testified before Congress last week that while China’s demand for oil has increased by 920 million barrels in the past five years, demand for petroleum index futures has increased by 848 million barrels. This means the effect of speculators in just about as large at all the growth from China. This is amazing.

Therefore, it is clear that demand is rising, but it’s not just from growth in emerging market economies. That part of the equation is relatively easy to quantify. The wildcard and the one which I believe has more to do with the recent parabolic spike we’ve seen in crude prices, is from the new “Index Speculators” as Mr. Masters has called them, or institutional investors.

黄河之水天上来

In this last part of my series on the oil bubble, I am going to take a look at the supply side of the equation and touch upon why Congress might be as much to blame, or more so, than the oil companies at which they are currently pointing fingers. (In case you missed parts one and two, here are the links to them: Part 1  and Part 2.) For decades, the U.S. has had no real energy policy with which to hang your hat on. I remember in the early 1970s seeing funny commercials on television rallying people to get more active in conserving energy. However, conservation isn’t an active strategy for increasing supply.

Congress continues to search for scapegoats to blame for this mess, whether it is the big oil executives, financial speculators, or futures exchange regulators. However, they continue to show their failure to grasp the bigger picture, which is to increase domestic supply. Just over a week ago, the Senate refused to lift its ban on developing the oil shale in the Rockies, where estimates have put the amount of oil locked in this shale, stretching from the U.S. to Canada, at more than 1 trillion barrels. Can you imagine?

Congress has come up with a bevy of misguided “solutions,” including limits on CO2 output, restricting drilling on public land; windfall profits taxes on big oil, and trying to sue OPEC. None of these will help increase the supply that is needed to meet growing future demand. The primary solution should be tapping our own domestic supply sources, which remain out of reach.

The “windfall profit tax” is just another example of Congress’ inability to focus on supply and demand. Do you really think that the government would do something productive with those extra tax revenues if they got them? Moreover, why would you create a disincentive for the oil companies, when what we need is for them to invest more in exploration and drilling? A recent report from the International Energy Agency [IEA] warned of a potential global supply crunch, but said that it could result from the failure of governments – not private oil companies – to open up their lands for more exploration and development.

Reports out of countries like China and Brazil show they are getting the message. China reported 10 new oil discoveries last year, and Brazil has reported some huge finds this year, all of which bode well for those countries. Europe is also  increasing exploration in the North Sea, but our Congress is leaving billions of barrels untapped as it worries about the profits of the oil companies. According to Investors Business Daily, since 2002 the U.S. oil and gas industry has earned roughly $0.08 on each $1 of sales, which is about the same level as the U.S. manufacturing sector as a whole. It seems to me that the notion of windfall profits itself goes against the ideals of capitalism and free market economies.

I am not one to completely ignore the environment either. However, I have read that Louisiana, where many of our drilling and refineries are located, is one of the top areas for fisheries, and that the fish have thrived amid the drilling infrastructure. So let’s stop putting the environmental lobby’s campaigns ahead of the national interest of the rest of the U.S. consumers. If we had started drilling in the Arctic National Wildlife Refuge [ANWR] back in 1995, when President Clinton vetoed the proposal, we would be producing an extra million barrels of oil per day now.

The facts of the matter are that for the last 28 years, Congress has opposed our drilling in Alaska’s ANWR, which we know contains billions of barrels of oil. They have also prevented us from building any new oil refineries, prevented from drilling in the outer Continental shelf of the ocean, and halted the building of nuclear and clean coal power plants. Together, had these initiatives been promoted, they would have gone a long way toward alleviating the problems we are facing today.

The Institute for Energy Research estimated that the combined supply of oil contained in the sources mentioned above amount to as much as seven times the reserves of Saudi Arabia. This could be enough to meet current demand in the U.S. for hundreds of years. Moreover, The Heritage Foundation estimates that if full-scale production begins within five years, the U.S. could end its dependence on OPEC entirely by 2020. So Congress, what are you waiting for?

So ultimately, who is to blame for the oil bubble? To be fair, there are other factors that I have neglected to mention: China is likely hoarding resources, Iran is storing tons of oil in tankers, OPEC is running below peak production, and refineries are running below peak utilization rates as well. Remedying these situations would help, but their impact is less than the potential of the initiatives Congress has the power to green light. I can only hope that they somehow see the light and decide that it is more productive to start looking at solutions to the problem, rather than focusing on scapegoats.

As a last point, I probably could do a fourth part on the theory of “peak oil,” but I fear I am getting a bit verbose on the whole subject. Suffice it to say, I am not sure I believe in peak oil. Who is to say how much oil is still out there in previously hard to reach areas, or sources that were considered uneconomical to explore? However, these arguments lose sight of what really is important, and that is how long will oil supplies last? I think as alternative energy sources continue to become mainstream and as current transportation and industrial methods continue to use less energy for input sources, that we will deem the notion of running out of oil misplaced.