Is Crude Oil In A Speculative Bubble?

By: Guy Lerner | Fri, May 16, 2008
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I was being interviewed for a web based business program, and I was asked the following question: Is crude oil in a speculative bubble? My answer was an unabashed no.

My definition of a price bubble is when both price gains and the fundamental outlook are unsustainable. Take the blow off to the bull market in 2000 for example. The parabolic gains of the prior year at a plus 30 price/ earnings ratio were unsustainable despite the much heralded productivity gains and new age efficiencies. The result was a bubble of epic proportions. The housing bubble is another example where both asset prices and fundamentals got too far ahead of themselves. Fueled by new age financing, the fundamental picture and price gains were unsustainable leaving market forces to correct the situation.

So is crude oil in a speculative bubble? To me, it seems that equity bulls frequently ask this question because it is the only way to explain a situation they don't completely understand. It must be a bubble fueled by speculators (i.e., the bad guys) as there is no fundamental basis for $125 per barrel crude oil is an often refrain. If only crude oil would cooperate, the stock market would do better.

The fundamental drivers for higher crude oil are: 1) geo - political concerns; the recent hostilities in the Middle East are enough for a $20 a barrel war premium; 2) increasing demand in a world that is ever less dependent upon the US economy; 3) a finite supply; they aren't making anymore of the stuff and whatever they can get out of the ground is getting costlier to produce; 4) there is no real viable alternative at present; 5) no real political initiative in the USA to seriously curtail usage or to seek out new alternatives; 6) dollar devaluation; 7) inflationary pressures as too many dollars chase too few resources.

Now crude oil prices may be getting ahead of the fundamentals, but for a bubble to exist both fundamentals and prices must be unsustainable. The fundamental picture is very real and likely to be with us for a long, long time. The fundamental picture is not unsustainable; it is reality.

Now why bring all this up when I generally write about technical or quantitative aspects of the markets? Well I got to thinking about crude oil and if it really was in a bubble fueled by speculators. If you look at some of the markets affected by the high prices of crude oil, you will actually see a very bearish picture for those markets. And my inference must be, if those markets are bearish then crude oil must be bullish.

Take the airline industry for example. If crude oil were unsustainable, then you wouldn't see the Amex Airline Index (see figure 1, a monthly chart) in such a severe downtrend. The breakdown from the 5 year base implies much lower prices. Or to put another way, crude oil will continue to be bullish.

Figure 1. $XAL/ monthly

The S&P Retail Index is another example. See figure 2, a monthly chart. This is a bearish chart. The close below the prior pivot low point (marked with red up arrow) is bearish. A break of the trend line would be even more bearish and likely lead to an acceleration of prices lower. Lower prices in the retail index imply higher prices at the pump which means higher crude oil prices.

Figure 2. $RLX/ monthly

Lastly, let's speculate on a top in the Dow Jones Transportation Average. I have been showing figure 3 (a monthly chart) for about 6 months now, and I am still not wavering from my contention that a head and shoulders topping formation is in the works. Why would the transport sector be topping if oil was ready to sell off? The more likely scenario - if this is a top for the transports - is that oil will continue its upward pressure.

Figure 3. $TRAN/ monthly

So let's summarize. My point here is to question the notion that crude oil is in a speculative bubble. It is my belief that if crude oil was going to reverse its upward ascent, then this would be reflected in the markets that are directly affected by higher crude prices. In other words, industries like the airlines and retail would already be discounting lower crude oil prices. But they are not, and on this basis, I must assume that crude oil is not in a speculative bubble and that the fundamental and price picture is reality.

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Guy M. Lerner may be reached at guy@thetechnicaltake.com.

 


 

Guy Lerner

Author: Guy Lerner

Guy M. Lerner
http://thetechnicaltakedotcom.blogspot.com/

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