Oil in a Bubble?

By: David Chapman | Fri, Jun 6, 2008
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We keep hearing that oil is in a bubble. Google "oil in a bubble" and watch scores of articles pop up. There are recent articles on CNN Money, the Guardian and the Washington Post and more. Every time we turn around it is the "sujet de jour" on BNN and CNBC. George Soros says we are in a bubble. George Soros has made more money in a minute then I have made in my lifetime, so maybe we should pay attention to him. So it is no surprise that when asked who has caused the price of oil to soar from lows of $11 in 1998 and $50 in January 1997 and $86 in February 2008 to the recent high of $135, many reply - speculators.

When in doubt, blame the "speculators". Many people, including the talking heads and especially the politicians, will nod wisely and agree. And then someone knowingly pulls out a chart of oil and says "Look, it has gone parabolic". The CFTC (or Commodity Futures Trading Commission for those who do not know the acronym) began a probe into so-called speculative trading. That caused an immediate drop in speculative net long positions. Gee, maybe there is something there after all.

But just who are the "speculators"? Hedge funds, sovereign investment funds (SIFs), index funds and others. And those others include pension funds. That pension funds would be classed as "speculators" is incredible in itself. It has been well noted that since 2003 the amount invested in commodity funds has soared to some $260 billion, from $13 billion.

Speculators are the easiest target to blame. But they don't actually own any oil. They buy the futures, and then when the time comes they roll into the next contract. In other words they are trading paper oil, not the real stuff. Grant you they do use incredible leverage to purchase their oil and all the funds flowing into the sector do create a certain hype, but they are actually not buying oil to use as they neither add to supply nor create any real demand.

Further in looking at the CFTC's Commitments of Traders Report (COT) we can't help but note that the net long position for the large speculators is only 53 per cent. This is down from 56 per cent the previous week as there was a big drop of 27,000 contracts in the long open interest. But at 53 per cent we would not term that overly bullish. The commercial COT most recently sits at 50 per cent, again not overly bullish.

We believe that all the talk of speculators being the cause of the rise in the price of oil as being pure fiction, although some very respected analysts believe otherwise. They are a handy scapegoat when you don't want to examine the real reasons. If one examined the prices of commodities that don't actually trade on any exchange, some of them have risen faster than have oil prices or most other futures-traded commodities. They include numerous metals, materials and agriculture products. Examples are cobalt, magnesium and molybdenum in the metals group, or asphalt and asbestos in materials and in the agriculture sector milk, tomatoes and grapes.

At the same time that he was blaming speculators, Soros acknowledged that there was indeed a tight balance between supply and demand. There is the great theory of "peak oil" which is also being blamed, but in fact the world is actually awash in oil when one considers untapped reserves in the Mid East, the huge reserves of the oil sands in Canada and Venezuela, shale fields in the US and again in Venezuela, and huge potential resources in untapped places in the Arctic and other remote and unwelcoming spots.

The trouble with oil sands, shale fields and the Arctic is that it is expensive to find and retrieve oil there. It is very dirty in the case of oil sands and shale fields, pollution is already a problem, and finally it is in environmentally sensitive places where one misstep could cause an environmental disaster.

The world also has plenty of coal which could be converted to oil, but that too is dirty and much of the technology to clean the coal is still in its infancy. Shale fields in the US alone could supply the US with oil for 110 years at current rates of consumption, but since oil shale is not really oil the ability to actually convert it for commercial production is insignificant. Meanwhile alternative energy sources are still expensive to develop and to date still supply only a small amount of the world's energy needs.

The world is facing the depletion of existing fields. The Saudis for example, who still have the world's largest reserves, have little room to increase production at least for the moment or what they have is not the easily refinable oil the refiners like. They are in the process of increasing drilling and hope to be able to produce another 500,000 bpd but we are at least a year away from that. Other developments there could increase production further in 2009-10. Brazil has made one of the largest discoveries in years but it will be some years before that can be brought to market. The US itself has some large potential up in North Dakota and Montana.

But the fact remains that fully 65 per cent of the world's remaining reserves are in the volatile Mid East. Iraq, for example, has an estimated 115 billion barrels of oil but it is also estimated there is probably another 100 billion barrels of oil lying just under the sand.

Yet today the Iraqi oil industry remains underdeveloped. The US, which illegally invaded Iraq in 2003, is bogged down in a no-win insurgency that has now gone on for five years. Attempts to sign deals that would in effect turn the huge potential oil reserves of Iraq over to US oil companies remain unsigned today as the factions in Iraq can not agree. Iraq today produces less oil then they did under Saddam Hussein under sanctions let alone what Iraq used to produce prior to Gulf War 1.

Prior to the 2003 invasion Iraq was refusing to accept payment for oil in US dollars, the world standard for pricing oil, and in an attempt to develop its oil fields Iraq was signing deals with Russia, Germany and France amongst others. US oil companies were shut out of any role in the development of one of the world's largest remaining oil reserves.

While many love to blame OPEC, the reality is that OPEC produces only about 40 per cent of the world's oil. OPEC is not to blame. But the other side of this is that vast reserves of oil are held in countries where the oil industry is inefficiently run, or which are hostile to the West, particularly to the US. Iran and Venezuela are both hostile and inefficient (even though Venezuela supplies over 10 per cent of the US's oil; Iran like Iraq produces less oil today then they did a decade ago despite having the world's 4th largest reserves as they too suffer under US led sanctions); in Russia and even Mexico the industry is quite inefficient. Russia, Iran and Mexico are the world's second, fourth and fifth largest producers.

The US still consumes roughly 25 per cent of the world's energy supplies with barely five per cent of the world's population. Recent indications are that demand in the US is actually beginning to decline with higher prices. But with demand in India and China growing, and a population seven times the size of the US, the strain on the globe's current supply is huge. And demand is growing according to the Energy Information Administration (EIA) even though it has tailed off a bit of late and is growing more slowly. But supplies are also constantly being squeezed, with conflicts in Iraq and Nigeria and weather threats in the Gulf of Mexico and the North Sea. It is always touch and go when it comes to supply and the world produces oil sharply below capacity.

Finally, numerous countries including China, India, Indonesia and Venezuela subsidize consumer oil purchases. In the case of China and India it is being done to help fuel the growth of their economies and develop domestic auto industries. But it is becoming a very expensive proposition and some, such as Indonesia, are trying to ease out of it. But China in particular has little desire to do so as it would harm their economic growth and could cause unrest, especially in the year of the summer Olympics. No matter what, a solid demand floor remains there for oil consumption as it is not impacted by higher prices as we are here in North America and Europe.

One reason we may feel we are in a bubble is the forecasts coming from reputable investment banks such as Goldman Sachs, Lehman Brothers and CIBC and others, where they have boldly predicted $150 and $200 oil in the not too distant future. It is these kinds of predictions that make one remember the predictions at the height of the dot-com boom. We remember the calls for Nortel Networks to rise to $200 and Amazon.com to $400 (pre-splits). Today Nortel trades at $8 after a ten-for-one reverse split, so 80 cents against a prediction of $200. While Amazon.com did rise to $400 (pre-splits), it too eventually succumbed in the dot-com bust and fell to $10, or around $50 pre-splits.

But the fact that companies like Goldman Sachs and others make these bold predictions forces us to look at who actually controls the trading in futures. To no-one's surprise, Goldman Sachs comes top of the list. It was a founder (through another company) of the London ICE Futures Exchange that trades petroleum futures. And Goldman runs the GSCI, which is probably the world's most widely followed commodity price index and is heavily weighted in oil. So maybe we could argue that speculators control the price after all.

Much has been said about the backwardation of the futures curve. In backwardation each successive futures contract is lower in price then the previous one, or a downward sloping forward curve. That indicates that while the spot price is high, the expectation is that prices will fall in the future. Oil futures (and a number of other commodities) had been trading in backwardation. Today that shift is moving to contango, meaning that the expectation is that prices will be higher in the future, or an upward sloping forward curve. If that is the case then inflation is becoming built in to the system and that will have serious ramifications down the road. As long as the oil price was in backwardation it was the buyer at source (spot market) that was paying the higher price.

When we think of a bubble we think of a commodity or stocks that are going parabolic. Parabolic means that the stock, the commodity or the index is rising almost daily and corrections are few and shallow. Bubbles in the stock or commodity markets are not that frequent but over the past decade or so we have had the Internet/Technology NASDAQ bubble of the 1990s followed by the housing bubble plus the LBO (leveraged buyout) craze. All bubbles are created by too much cash chasing too few stocks, or houses, or the commodity. They usually occur at the end of a cycle after years of steady rises.

A case in point is the NASDAQ bubble. Our monthly chart below shows the NASDAQ of the 1990's. We also show the US Dollar Index. From the lows of 1990 the rise on the NASDAQ was for the first several years slow but steady. It was punctuated by corrections in 1992, 1994, some in 1996 and 1997, and a steeper correction in 1998. From the lows of 1990 to the highs of 1998 the gain was 516 per cent. But the gain from the lows of 1998 to the highs of March 2000 was only 282 per cent, or less then the earlier gain. Yet it was this latter period that was considered the real bubble period.

There are some interesting characteristics. First the period 1995 to 2000 saw a rising US dollar. The rise in the dollar was triggered by a coordinated attempt by the Federal Reserve and the Bank of Japan to stem the drop in the dollar and the rise in the yen. This set off the famous yen carry trade, whereby large investors were able to borrow in cheap yen, convert to dollars and invest in higher-yielding US dollar bonds and stocks (and elsewhere as well).

It was also a period where both money supply (M3) and debt rose. We no longer have the figures on M3 as the Fed stopped reporting that in 2007, but the narrower definition of M2 money grew from 1994 to 2000 by 35 per cent, or 5.8 per cent annually. But debt grew by 39 per cent, or about 6.5 per cent annually.

That the Fed no longer publishes M3 figures is in our opinion an attempt to avoid showing rapid monetary growth. M1 is basically money readily convertible, meaning cash and chequing accounts, while M2 adds primarily what is in savings accounts (including certificates of deposits and money market accounts). But M3 added in the large deposits of banks, institutional money including mutual funds, Eurodollar deposits and repurchases agreements. In other words it is what is held by the large financial institutions. It is felt by many economists to be best measurement of how the Fed is creating money and credit in the financial system.

So this rapid monetary growth during the period played a major role in the rise of the NASDAQ (and other stock markets at the time). With the rising US dollar as well it is interesting to note that commodity prices fell during this period. Gold fell from about $400 to $250; oil fell from a range of $15-$25 to $11.

Now let's look at a chart of oil from 1999 to 2008. Oil prices have leaped over 1,000 per cent during the period. But unlike the period of the NASDAQ rise, the dollar topped out in 2002 and began a long decline. Note that there were important lows for oil in 2002 that coincide with the top in the dollar. That commodities and the dollar are inextricably linked is clear. A rising US dollar means falling commodity prices, while a falling US dollar means rising commodity prices. All measures of commodities have been rising during this long period of a falling dollar. The same phenomenon was seen in the 1970s; the rising trend of commodities was reversed when the dollar began to rise in the early 1980s.

This past decade has also seen huge growth in money and debt. Since the end of 2000 money supply (M2) is up 56 per cent. M3 growth is considerably higher. Debt growth during the period is up even more, at 75 per cent. Of course the period also saw the housing bubble but that topped in 2005-06 and has since burst. Oil prices kept on rising. Some have blamed the Fed for the rise in the price of oil because of the huge rise in money and debt (massive liquidity for the financial system), and also in keeping interest rates low below the rate of inflation. While the reality is that oil prices are a function of supply and demand they are also a function of the US dollar. It is not always a perfect match as there are periods where the dollar fell and oil prices fell, and when both rose together as well.

This is what we call an observable event, easily seen by just looking at a chart of the two. Given that we now have three consecutive months where the dollar has gone up (albeit small gains), odds might favour oil prices correcting. Since January 2007 oil prices have been rising sharply. But during this period the US Dollar was falling sharply. If you want to know why oil prices have risen so sharply you need look no further then the falling dollar - 40 per cent from 2002 to 2008. If oil is in a bubble then the dollar is in a "de-bubble" if there is such a word.

Since the lows in January 2007 the rise that has seen oil prices go up some 110 per cent has had very few corrections. But we note as well that the US dollar has had very few corrections during the same period as it marched inexorably downward. Prior to that time oil prices rose in a stair step fashion, a characteristic of a technically strong market.

So is oil in a bubble? We do not believe so. The dollar is in a long decline and until it stops falling oil prices will keep on rising. Add in the still growing global demand in the countries where fuel has been subsidized plus the potential for war in the Mid East, and we could yet see those prices of $150 and $200.

Near-term, though, the dollar is currently being supported by talk that the Fed will no longer cut interest rates, and because of rising inflation might have to hike interest rates, and this might cause a correction in oil (and other commodities). But given the state of the US economy, they cannot afford to hike rates and indeed may have to cut further. So the talk is just talk or jawboning as the Fed has recently noticed that the US Dollar is weak (normally the US Dollar is the concern of the US Treasury not the Fed). The inflationary impact of a falling US Dollar and rising oil prices is a fight that will have to come much later. Right now the focus of the Fed is on the weakening economy. And as before they are lowering interest rates and flooding the financial system with liquidity in order to stem the weakening economic outlook.

We leave you with a chart of the 1970s and into the 1980s, where oil prices rose to $40 in 1979. During the same period the US dollar was on a relentless downward march. It was also a period of rapid monetary growth (everyone paid attention to M3 back then and waited anxiously for the weekly numbers) and a period of rising bond rates and inflation and short rates kept below the rate of inflation because of concerns about the economy. It was Paul Volcker taking over at the Fed and changing course to fight inflation and hiking short rates that helped trigger a sharp rise in the dollar and a subsequent collapse in oil prices and other commodities (especially gold).

If you believe that oil and other commodity prices are going higher, you should cheer for a continuance of Ben Bernanke as head of the Fed who will be more than happy to assist us with massive amounts of liquidity, interest rates below the rate of inflation and of course giving us the resultant falling US Dollar. On the other hand if we get wind that a Paul Volker clone is about to take over the Fed, oil (and gold) bulls should run not walk to the exits. But oil in a bubble? No. It is the US Dollar in a "de-bubble".



David Chapman

Author: David Chapman

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