Tuesday, September 18, 2012

Oil: The Mother Of All Bubbles?

The media are clueless and the pundits are vexed: The price of oil is falling. Yesterday the oil price suddenly dropped $3 on the financial markets - "for no immediately obvious reason", wrote Barrons (blogs.barrons.com). The European type oil Brent Crude plummetted 2.5% (bloomberg).  

Oil costs now less on the financial markets than it did Thursday afternoon minutes before QE3 was announced. How could that be? The experts tell us that OE3 should spark inflation and push the price of oil higher.

I reckon that the sudden price drop is another sign that oil market is the mother of bubbles. This is why:

Minutes before the oil price drop, Bloomberg reported that "hedge funds raised bullish bets on oil to a four-month high before futures surged on the Fed’s plan to buy $40 billion a month in mortgage bonds in an effort to accelerate the U.S. recovery".. (bloomberg). Furthermore: "Money managers increased net-long positions, or wagers on rising prices, by 5% in the seven days ended Sept. 11, according to the Commodity Futures Trading Commission’s Commitments of Traders report on Sept. 14. They were at the highest level since the week ended May 1".

Oil futures are traded on the financial markets like stocks, bonds and other assets. The oil price therefore is in the hands of hedge funds and other speculators who are betting huge amounts on expected price changes. The result: The price of oil doesn`t reflect fundamental factors any more. The market ignores supply and demand, and instead focuses on theories and speculation which are used as  excuses for high and rising oil prices.

I reckon that at least in the last 2 years hedge funds and other speculators have been massively buying oil futures which inflated the price of oil into a huge bubble. For years oil speculation has been driven basically by 2 arguments: The peak oil theory and possible supply disruptions from the Middle East.

The peak oil theory claims that we are soon running out of oil. It ignores technical progress like fracking and deep sea exploration which allows exploration of more and more oil reserves. 

For years the continuous wars and unrests in Middle East (Iraq, Libya, Syria, Palestine, Egypt et. al) and heated speculation about Iran´s nuclear policy have been abused to poke fears about sudden supply disruptions.

The speculatively excited oil price rise induced 2 developments:
 1. The sharp rise of oil production in the USA thanks to the fracking boom. I reckon that other countries will follow. Fracking and more deep sea exploration could flood the oil markets in the coming years.
2. A shrinking demand for oil in industrialized nations because companies and consumers are getting more energy conscious and more efficient.  Helpful is the technological progress again which brings us more energy efficient cars, refrigerators, air conditioners and other devices. The sluggish global economy has also been curbing the hunger for energy.

I suppose that both developments have been leading to growing over-supplies which could squeeze the oil price down.  

The history shows that a price bubble can grow over years - fueled just by the beliefo in rising prices. But at a certain point the bubble gets to big and it pops. Maybe we reached this point again.  

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