Oil Bubble? Seriously? Oh, Yeah

What has been driving the cost of oil so wildly and erratically over the past several weeks? Where will it all end? How high can the price of oil go without toppling the global economic cart?

Before getting to the underlying causes of the current rapid expansion in the oil price bubble, we should consider how much higher oil may go in this cycle. The answer is, not much higher. The reason is that global economies are having trouble dealing with current prices. Any higher and a global recession will ring the gong on this act.

...the price of oil is extremely cyclical - that is, it tends to rise during economic booms and fall during contractions. It dropped 44 percent in the last recession (from November 2000 to November 2001), 48 percent from October 1990 to January 1992 - and 71 percent from July 1980 to July 1986. __Source

A full blown recession is not required to trigger an oil price drop, but if it happens, the fallout for many financial institutions will be worse than fallout from the recent credit crisis.

All consumers are beginning to cut back on oil consumption. Current high prices are driving consumption down, and will eventually drive production (and substitution) up.

It takes a while to develop new supplies of oil, but the signs of a surge are already in place. Shale oil costing around $70 a barrel is now being produced in the Dakotas. Tar sands are attracting investment in Canada, also at around $70. New technology could soon minimize the pollution caused by producing oil from our super-plentiful supplies of coal.

"History suggests that when there's this much money to be made, new supplies do get developed," says Brown.

That's just the supply side of the equation. Demand should start to decline as well, albeit gradually.

"Historically, the oil market has under-anticipated the amount of conservation brought on by high prices," says Brown. Sales of big cars are collapsing; Americans are cutting down on driving. The airlines are scaling back flights.

We've learned another important lesson from the housing market: The longer prices stay stratospheric, the worse the eventual crash - simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce. __Source

But why have oil prices shot up so quickly? 1. Huge recent demand from China, India, and other emerging nations. 2. Recurrent, transient political turmoil in oil producing regions 3. National oil companies that have no incentive to modernise production as long as prices remain elevated 4. The reduced value of the US Dollar causes oil prices to rise relatively 5. A speculative bubble driven by index fund/pension fund investing.

Much of the rise in oil price is the result of activity on the New York Mercantile Exchange, the energy exchange. This is activity by index funds and pension funds that are investing in oil futures, not for direct use but as financial assets for profit. That contrasts with activity by oil producers and consumers who buy and sell to smooth out fluctuations in price and delivery.

These financial institutions – index funds and pension funds – are neither buying oil nor selling it. They are passive investors in commodities. They have invested $260bn (€169bn, £133bn) in commodity markets, compared with $13bn just five years ago. Much of this money is in oil.

...The best way to counter speculation is to make it less profitable. Step one is to protect the regular traders in the real oil economy (those who intend to close their positions by making or taking delivery of oil) and charge them a lower margin than those who have no intention of plying the oil trade. The purely financial traders must be made to pay a proper price for their speculation. This can be done simply by increasing the margin that they have to put down to trade as open interest, from the current 7 per cent to about 50 per cent. __FT

This huge speculative bubble is often overlooked due to peculiar bookkeeping allowed by a government loophole.

Even though they are speculators, they are not included in the data as speculators. Because they get their exposure from an investment bank, they are ultimately listed as a commercial. In total, they represent an enormous part of the commodities markets. But they are providing liquidity, so what's the problem? They are not actually hoarding the commodities. The price is still set at the spot price. But.

But that is not the whole story. They are making it difficult, if not dangerous, to short the market. When massive buying comes into the market, it moves the market and sends the signal to the market that prices are rising. Momentum players move in, and prices rise some more. __Source

Prices continue to rise more, and more, and more . . . because in effect, a ratchet has been inserted into the mechanism allowing quick price rises, but working against falls in price.

Hiding as commercial accounts, thru a Commodity Futures Trading Commission exemption to avoid speculative position limits, these institutional-investors use commodities index-futures to hold positions in oil. But not as traditional buyers of oil would, but as financial speculations. This feeds the demand side, without ever, actually demanding oil. Eighty two percent (82%) of WTI futures [net increase from 01/01/03 to 03/12/08] was purchased by institutional-investors [Testimony of Michael Masters before the Committee on Homeland Security and Governmental Affairs, U.S. Senate, p.3, May 20, 2008].

He further notes that Index Speculators “never sell” their positions but, “roll their positions by buying calendar spreads.” True, their positions are closed but then they are continuously reopened. According to Michael Masters the increase in institutional-investor position's on WTI futures increased 539% over five and one-quarter years [102% per year on average]. Momentum in price attracts attention and so more and more institutions enter trades, ratcheting the price upward. How can experts claim that such an influx of non-traditional buyers into index-futures, at this magnitude, does not effect spot prices?

Answer: they cannot. The pricing signal that index-speculators are sending to the spot market is a false signal. Their financial demand is only for oil futures, not barrels of oil. For persons to claim it is really the huge demand [2% per year + marginal decline] or supply disruptions [that never happen] is to be otherwise engaged. __Source

Even George Soros is concerned about the level of speculation by pension and hedge funds in the oil market. Soros recently testified before Congress on the issue. Now Senator Joe Lieberman of Connecticut is threatening to close down these big money price ratcheting speculators with the power of federal legislation. Given the paper profits these fund managers must be showing right now, imagine their concern over Senator Lieberman's comments.

What should you as a small investor do? Stay out of it. Oil prices may finally tip the US into a recession before all of this is settled. If so, the current bubble would no doubt pop, but it would not be long before the onset of the next bubble--unless substantive reforms are made in US fiscal policy, Federal Reserve policy influencing the value of the US dollar, and CFTC (Commodities Futures Trading Commission) policy in regard to "long-only" index futures.

More: See Bruce Hall's interesting take on fuel prices here.