Wednesday, March 12, 2008

Bursting Bubbles

The possibility of an oil price bubble has been discussed since at least 2005, when oil was trading in the $50s and $60s per barrel. At the time, it wasn't hard to justify that level and dismiss the notion of a bubble, based on the fundamentals of supply and demand. Lately the term has resurfaced, and I'm not at all sure that the arguments against it outweigh the evidence of large-scale speculation, including the apparent divergence between oil futures prices and the price of oil equities. To whatever extent oil futures and options appear to be an attractive hedge against resurgent inflation, a speculative bubble in oil would reinforce inflation and economic weakness, until events converge to burst the bubble, causing further disarray.

It's usually hard to discern a speculative bubble until after it has popped. In retrospect, the housing bubble seems blindingly obvious, now, along with the 1990s Dot-Com bubble. But why is it any likelier that today's roaring oil prices are evidence of such a bubble, when they clearly were not, a few years and $50 per barrel ago? After all, the US economy may be slowing, and US oil consumption with it, but global consumption is still growing, thanks to booming demand in China, India and the Middle East. Global oil demand has risen by 2.4 million barrels per day (MBD) since 2005, and suppliers have struggled to keep pace. The International Energy Agency recently estimated that OPEC has only about 2.4 MBD of spare capacity in reserve, barely another year's growth. Add the ongoing instability in Nigeria and the Middle East, sprinkle in a dash of Chavez, and you have the recipe for a tight oil market. The problem with this logic is that a very similar recipe added up to much lower prices in recent years.

In the absence of speculative pressures, oil prices are generally determined by a few main factors, though evaluating them is far from simple. Inventories and spare capacity are widely regarded as the key differentiators between a strong oil market and a weak one. Commercial oil inventories in the OECD countries are certainly on the low side, though still within their five-year historical range, except in Asia. Although US oil inventories fell unexpectedly last week and are about 6% below their level of a year ago, they are still smack in the middle of their historical range, based on data from the Energy Information Agency (see their chart below) and have generally been rising since the start of the year. On balance, this picture doesn't look more bullish than in March 2005, when oil was $55/bbl.

Now consider oil equities. Since last December 31, the front-month crude oil contract on the New York Mercantile Exchange has risen by 13%, while the Amex Oil Index (XOI), a composite of 13 large international oil companies, including ExxonMobil, Shell, BP, Chevron and ConocoPhillips, has declined by 9%--only 1% less than the drop experienced by the entire S&P 500 index. While it's true that these oil companies are exposed to rising costs and slumping US sales, it's hard to fathom that they wouldn't see any net benefit in their cash flows from a $10 spike in oil prices, relative to the broader market. Part of the explanation may lie in the fact that speculators don't need oil equities for exposure to the commodity; they can get that directly on the NYMEX and via the over-the-counter swaps market. The NYMEX/AMEX disconnect might not constitute proof of a bubble, but it's consistent with one.

Finally, we have the behavior of OPEC. It's certainly convenient for them to blame speculators for the current high prices, which earn them record revenues while producing nearly flat out. And they do bear a good deal of responsibility for higher prices, not because they've been squeezing the taps, lately--far from it--but because as the holders of 69% of the world's proved oil reserves, they've failed to invest in enough new capacity to ensure the market is well-supplied. However, despite strong elements of self-interest in their recent decision to maintain current production levels, the cartel seems to be on the defensive, rather than in the driver's seat. Perhaps they smell a bubble, too.

If the current oil market does incorporate a speculative bubble, it's worth recalling that many of the brokers and hedge-fund traders involved are too young to remember the collapse of previous commodity bubbles, such as the Silver Thursday demise of the Hunt brothers' scheme--also spurred by fears of inflation--to corner that market. And few would have experienced the sudden collapse of oil prices when Operation Desert Shield became Desert Storm on January 17, 1991. I traded petroleum products for Texaco in London at the time, and I can assure you that the last thing anyone expected was for the price of West Texas Intermediate to drop by one-third overnight, once the bombing started. Any speculator thinking he had ample time to unravel positions when the market turned got a very rude shock, indeed. As conservative as my company's trading rules and my own approach were, I lost several million dollars on a single cargo of jet fuel.

Time will tell whether $108 oil is the result of a bubble or fully justified by fundamental factors. If it turns out to be the former, the damage could be considerable. Because of the tremendous leverage of oil futures on the physical oil market, each dollar per barrel of speculative froth adds 2.4 cents to every gallon of gas and $4.4 billion per year to the US petroleum import tab, sending ripples throughout the economy. In aggregate this outstrips the speculative gains available to investors on the NYMEX and feeds the vicious cycle of dollar weakness and inflation. While that argument won't--and perhaps shouldn't--deter a single oil speculator, a careful review of the outcomes of past bubbles just might.

Disclosure: My portfolio includes at least one of the components of the Amex Oil Index.

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