Is Oil a Bubble? Part One

by: Jordan Kahn May 23, 2008 | about stocks: AMR / DBA / DBC / F / JJN / OIL / USO    
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Jordan Kahn

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Oil is now front and center on everyone's radar. Last night, CNBC ran a special tonight about oil, and had a banner running across their ticker titled "America's Oil Crisis." Congress is looking for scapegoats to blame for high oil prices, and is hauling in oil executives to testify, and propsing stupid ideas like a windfall profits tax.

Funny, look at the first chart below of wheat (and the chart for corn looks identical). Looks like wheat and corn have had parabolic moves higher, but I haven't heard any talk of windfall profit taxes on the farmers. Rather, Congress is trying to pass further subsidies for the farmers, who are arguably in the best position of any industry in the country.

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The next two charts show the extreme, straight up moves in other commodities. I have included lead and nickel, but there are several that fit the bill. What I am highlighting is that these parabolic moves higher are never sustainable. And when they eventually run out of steam, they usually succumb to large corrections.

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Given what we have seen in many of the other commodities, take a look at the chart below for oil. Look similar? If I showed you the charts for all of the other commodities, a logical conclusion would be that the trajectory of the upward moves was unsustainable, and susceptible to a sharp pullback.

However, for oil, for some reason, people think that the recent high prices are a sure signal that $150 and then $200 are right around the corner. Now I want to be the first to say that I have no idea how high oil will go. To be honest, I am surprised it ever reached $135.

Unlike stocks, which can shoot to the moon, high oil is self-defeating. As prices skyrocket, it slows economic activity and can bring some forms of transportation to a halt (just look at the news from AMR Corporation (AMR) that it is cancelling flights, and Ford (F) is curtailing production on some of its gas guzzling vehicles). That, in and of itself, would cause a correction in the price of oil (as demand trails off).

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The chart below is from the good folks at Bespoke. It shows the relationship of the current oil bubble to the last 2 big bubbles in tech stocks and then the housing market. This week, the rise in oil eclipsed the mammoth rise in tech stocks in the late 90s. Pretty incredible, huh?

And we know what the end result of those two bubbles were, right? They both ended very badly, especially for folks who got sucked in anywhere near the top. Which brings me to the million dollar question: where is the top?

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No one knows for sure where the top is, and those that tell you they do are simply lying. If you had bailed on tech stocks in 1998, you missed quite a move higher still. If you sold your house in 2004, you left a lot of money on the table. So my hunch is that I want to remain long oil/energy names, although I do not want to chase the recent move higher.

That said, when this bubble bursts, most people won't believe it and will continue to buy on the way down. But history tells us that we should look for those signals as a reason to lock in profits for good, and then simply move to the sidelines.

[In Part 2, I will delve into who is really to blame for high oil prices (hint: it's not the oil companies).]

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This article has 106 comments:

  •  
    May 23 06:46 AM
    not really sure I understand the logic here. the demand for oil is real and necessary. we can not live without it. and it is a global demand. no one had to have nasdaq stocks or a new house to survive.
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  •  
    May 23 07:13 AM
    Pap ---Not true. The Nasdaq is necessary. People need jobs. There would be no jobs w/o capital. Try to live w/o a house in Maine.

    Very good paper Kahn. No matter how many times bubbles happen. Pleople always say its "different this time".
    Reply | Link to Comment
  •  
    May 23 07:14 AM
    Oil is King today as is Gold. Invest but have a hair trigger and be ready to take profit. Hogs they bring to slaughter
    Reply | Link to Comment
  •  
    May 23 07:17 AM
    Yes, oil has got ahead of itself. This weeks capitulation of the oil bears shows it and it will correct. But to call a similar crash like the tech bubble is ridiculous.

    It is complete nonsense, to compare wheat to oil. The supply picture for wheat changes every year, oil's doesn't.

    And please: To say that AMRs move will cause the oil crash is a bit daring, wouldn't you say? Airlines have been managed incompetently and restrained by unions when oil was 10 bucks and they went broke at 10 bucks a barrel.

    The same goes for Ford. A bureaucratic union restraint organization which will hopefully go bankrupt soon along with GM. Why does every carmaker in the world from Mercedes over BMW and Volkswagen to Toyota and so on want to produce cars in the United Sates? Because it pays! Ford and GM simply suck!

    Established demand destruction doesn't apply today, because unlike in previous decades the world is out of capacity and the 400.000 barrels we use less are getting sucked up easily from others. May be when the emerging markets stop emerging and go as developed we can calculate as we used to.

    As I recall, in January a lot of people called an end to the commodities boom when the Baltic Dry came down rather swiftly. Hoopla, it is at a new high, economies around the world report high growth rates, most of the times against expectations.

    May be it is because there are folks out there, who unlike us, don't have to beg for credit so they can buy stuff. They have the money we shipped overseas in exchange for goods, because we are to inefficient to produce these goods ourselves.

    So what are we doing: We complain and look for witches we can burn at the stake. Great that always helped - for centuries.

    Instead we should buy more efficient cars, trucks and aircraft and we should kick some serious Washington butt until they open up every area for drilling, so may be we get some more oil of our own in 10 or 15 years.

    May be our leadership should stop begging the Saudis for more oil. What a humiliation. We saved their butt more than once and know we beg on our knees: Please, please great king. Give us a little bit of oil! Because they worry about what the sight of an oil rig would do to the coastlines at home.

    That is why we are loosing. We complain and drown ourselves in selfpity, while others do stuff.

    Brazil can do it, we can do it. I think we have more coastal waters than Brazil.
    Reply | Link to Comment
  •  
    May 23 07:29 AM
    @papita: REAL demand for oil hasn't changed all that much, but "paper"deman... for oil-futures has been skyrocketing over the past years. contrary what the most media-guys tell (mostly due to lack of knowledge and lack of skills and willingness to thoroughly research a story before publishing crap) it is not an issue of real supply real demand-disruptions or threats thereof. nothing the like has developed since decmber to justify a 40% spike in prices.
    i suggest you read this sa-article referring to a recent eye-opening testimony about impact of speculators and pensionfunds(!) on oil prices before the us senate:

    seekingalpha.com/artic...
    Reply | Link to Comment
  •  
    May 23 07:32 AM
    You were being very subtle to say the least, and equally brave. High time somebody spoke some sense. I can't wait for part two, which you were blatantly building up from the beginning.
    Reply | Link to Comment
  •  
    May 23 07:34 AM
    Great discussion. I vote with Papita and Ship Shape. An 'oil bubble' will become a reality, when we start conserving, and/or the developing countries are no longer emerging. We Americans look at the world only through our own perspective, and that ignorance of what is actually happening here is going to cost us big time. Those billions of Chinese, Indians, et al, want what we have, and are making progress towards getting it. They are buying cars now, instead of bicycles, and it is not going to stop just because we don't like it. We are beginning to take some basic steps towards doing some things right, but we have a long way to go, and the rest of the world is not waiting for us to figure this out. I'm holding my oil positions until I see some genuine progress, and at this time that seems a long distance into the future.
    Reply | Link to Comment
  •  
    May 23 07:37 AM
    By the way, the 'oil is bubble' - discussion is in a bubble itself. I have never in my life, seen and heard so many people call a bubble, than in this particular instance.

    Being a contrarian, I will wait for a pullback to take out my stop-loss limits and get back in, when oil bottoms between 95$ and 105$.
    Reply | Link to Comment
  •  
    May 23 07:41 AM
    @red baron: are you even aware of the fact that most emerging market economies, esp china dn india are subsidising oil and gasoline to a very large extent these days to their citizens? China consumes much more oil in relation to its economic output than the u.s. (not to speak of much more energy-effcient economies in europe). as long as people get cheap oil and gasoline there they have zero incentive to save. now, the problem comes in exactly here: everybody assumes china has huge $ reserves to buy up the entire world with. but how long will they last to support domestic prices while oil prices keep escalating? how much loneer can less capitalized emerging economies sustain their subsidies? and the moment they can't anymore, economic activity will slow down very dramatically! which, in turn, will btw also affect agricultural output.
    I think, that oil will go down substantially, it's long-term uptrend notwithstanding while grains and agricultural commoditoies will stay high and climb higher. there is speculative money in them, too, but demand growth there is much more real than in oil and while you can stop driving for a month - you cannot stop eating
    Reply | Link to Comment
  •  
    May 23 07:48 AM
    fxtrader07

    Do you even realize, that without oil, there is no grain production. And if there was grain production, you couldn't transport it to consumers.

    10 calories of oil equivalent are spent to bring 1 calorie of food from the field to your table.

    Oil makes the price of everything.

    And if there is anyone badly capitalized, than it is us.
    Reply | Link to Comment
  •  
    May 23 07:51 AM
    I really hope its a bubble, this is really just nuts what is going on - All of the oil stocks I am watching began to cool down I hope that oil follows
    www.investorslive.com/.../
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  •  
    May 23 07:56 AM
    There are two predictable threads that pop up on Seeking Alpha time after time.

    1) When people discuss commodity supply/demand, they always mean within the U.S. until they get reminded that there's other people out there.

    2) Commodities and commodity ETFs are expected to behave like stocks, and chart overlays are produced all the time reinforcing this misconception. Stock mavens new to commodities have real trouble recognizing the differences.

    And BTW, no farmer gets executive compensation like the heads of oil companies. So discussion of a windfall-profits tax for the ag sector is not in the cards. But a wpt for Big Oil does not offend my theology.
    Reply | Link to Comment
  •  
    May 23 08:00 AM
    FXTrader, yes I am aware of the way the chinese subsidize gasoline, but how is that different from what we do with grain and ethanol production? A gov't subsidy in the US is not any different than a gov't subsidy in China or elsewhere. We do the same thing!
    Reply | Link to Comment
  •  
    May 23 08:00 AM
    Ship shape I am convinced you didn't read the article.
    Reply | Link to Comment
  •  
    May 23 08:11 AM
    This kid (author) needs to get a passport and see the world. He had better wake up to the fact that the "third" World dude who was walking, now wants a bike. The dude who had a bike now wants a car.

    And so they will be having their industrial revolution now. They don't care about the falling U.S. Peso and what the price up crude is today.

    Deal with it. Inflation is here to stay.
    Reply | Link to Comment
  •  
    May 23 08:13 AM
    ZMaNFaRLee

    Why is that, Sir?
    Reply | Link to Comment
  •  
    May 23 08:15 AM
    The last two Business Weeks have featured articles about people making tons of money bringing previously ignored oil sources to market. Other articles, mentioned here, talk about how companies and consumers are starting to conserve.

    There is much discussion about how the prices are being driven by the "Emerging Markets". Having spent a lot of time in third world countries, I can tell you that those markets are far more sensitive to price swings than the US. Thus, if they are exposed to the same price swings, they are more likely to drop demand quickly.

    Of course, there are factors that make these scenarios "sticky" like the comments on subsidized prices in some countries. However, like the thousands of examples in history, governments usually have a hard time maintaining price constraints on commodities. They will move. Prices will moderate.
    Reply | Link to Comment
  •  
    May 23 08:17 AM
    The simple fact is that oil is at $130 a barrel. We have been talking about alternative energies since it was much cheaper, now/soon those alternative energies can get real margins going because of demand for energy. Maybe Oil makes it to $150 let's say, anything above that will be spikes and nothing more, oil can't stay that high without alternative sources eating up market share.

    In the end, high oil prices will be what helped us get away from it's leash. When 400 miles travelled can cost you $50 vs. $100 people will start thinking that an extra $2500 for hybrids/elictricals are pretty smart.

    Say what you will about emerging markets needing oil, if the U.S. cuts it's usage in half over the next 30 years oil goes down (adjusted for inflation ofcourse).

    Also don't forget..... OIL IS PRICED IN DOLLARS!!!

    see what happens eventually when rates go up (that is definitely more long term however)

    Disclosure:

    Disregarding numbers which were used to just have a number, the logic I don't think can be argued. There was an old saying in times long ago "No wood, No kingdom" wood was the fuel, then came coal, then came oil, next is something else. When people say oil is a necessity it just makes me laugh. Intelligence and ingenuity is teh necessity.

    Agree?/Disagree?
    Reply | Link to Comment
  •  
    May 23 08:23 AM
    Supply and Demand 101....Just because you get a PhD, it doesn't mean you can forget the first day of school.

    Prices will increase until demand shows some elasticity. When a rise in price causes a drop in demand large enough to create a net drop in revenue prices will stop going up.

    Of course the reaction is delayed, and we are still waiting for the demand side of the equation to react, but it is inevitable. Then comes the price correction.

    Timing the inevitable can be a bit tricky.
    Reply | Link to Comment
  •  
    May 23 08:31 AM
    Ship Shape... He was not using wheat or corn to show there must be a reversal but showing why putting a wondfall tax on corps in oil makes no sense.

    And AMR and ford he used as examples that trasportation is failing right now due to high oil which will in turn drive demand down for oil not that one company will take it down.

    I was a little harsh.... didn't think you were still looking at article :)
    Reply | Link to Comment
  •  
    May 23 08:35 AM
    I hope its a bubble.....but I think peak oil production will say otherwise.

    This price will rise high enough to put everyone in a global recession. as the economies try to expand again....it will again put the economies back into a recession until we can find another energy source.

    the problem is.....there is nothing out there that can dispalce the amount of energy from oil in any timely fashion.

    We currently use 3 cubic miles worth of oil for our total energy needs world wide.

    It is estimated that we will use 6 cubic miles worth of energy by 2030.

    1 cubic mile worth of energy is an equivelant of

    1,300 wind turbines installed every week for 50 years

    1 900MW nuclear power plant installed every week for 50 years

    250,000 solar panels installed EVERY DAY for 50 years.


    During that time frame...we will hit peak oil, peak NG, and peak coal.

    How do you grow economies without growing energy? We can get more efficient.....and maybe we can reduce our consumption of energy by 1 or 2 CMO worth.....but the math still doesn't work out.

    Its going to get ugly.....and neither price nor technology will increase our oil supply....just pull up a chart of USA oil production.....neither price nor technology changed our supply....why would it for the world?

    The true problem is too many people......or growth of either economies or population. its not sustainable.

    there is a couple of scenario's.

    demand falls while supply remains flat (lower prices) but as prices fall those expensive projects come offline

    demand tries to grow....but supply is flat. higher prices

    demand grows, supply falls, very very high prices

    demand falls, supply falls faster, higher prices.


    I think we are at demand is growing and supply if flat now...and supply will soon start to fall at 6% a year, year over year.

    Reply | Link to Comment
  •  
    May 23 08:44 AM
    One thing to note user is that reserves are based on what oil is profitable to get to. If oil Hits $150 maybe drilling through Ice in Russia becomes worth it economically, maybe boiling oil shale in Colorado becomes worth it, etc. The odd thing about oil and using the word production or reserves is that when price goes up so does supply..... odd as hell but absolutely true. This would make price increases in oil haveing an almost plateau like effect. So it would make sense to figure that into your numbers. It only takes one pipe in russia drilled through the Ice to change everything once again.

    I just hope we don't have to get it. Keep it in the ground and let us continue our work on alternative sources. It is extremely unfair to talk about how long it will take technology to offset current demands when technology grows faster than the price of oil.
    Reply | Link to Comment
  •  
    May 23 08:47 AM
    I see signs that we are beginning to conserve here in the states, but actual consumption of energy is still going up. At the same time, consumption globally is also still going up. There will be a correction in the price of oil, but the question is 'Are we there yet?' I don't think we are because of what I observe each day. Eventually, it will happen, but it is going to take more significant moves than what we come up with so far. We first have to un-do some of the mistakes we have made (i.e., ethanol). We are beginning to ask some of the right questions, but the solutions for us here in the states to me seem far in the future. In the mean-time, I will own oil and oil related stocks.

    I also am looking forward to Part II, which will likely promote more great discussion. I think such discussion, debate, or whatever, is a large part of the solution.
    Reply | Link to Comment
  •  
    May 23 08:50 AM
    reserves grow.....but the rate of flow of oil does not.


    its going from one well that produces 5,000 barrels a day in SA

    to huge capital, long lead time, low flow rates of oil from tar sands....which require huge amounts of resources...which could ultimately limit us. just do the research. Money can't defy physics...regardless of how much there is.


    Reply | Link to Comment
  •  
    May 23 08:57 AM
    We drill it, suck it up, and it flows. All I can say in defense. And I think it is a proper defense.
    Reply | Link to Comment
  •  
    May 23 08:58 AM
    "Do you even realize, that without oil, there is no grain production. And if there was grain production, you couldn't transport it to consumers."

    Anyone can turn this statement around and say, do you realize that without grain production there would be no oil because there would be no people alive to make the oil because they would all starve to death!
    Reply | Link to Comment
  •  
    May 23 09:04 AM
    gzlatin

    Congratulations! That is the best answer I heard in a ling time.

    Sure, you can produce food without oil, but there will be 3 billion people less to eat it.
    Reply | Link to Comment
  •  
    May 23 09:07 AM
    Jordan: Best I've read on the topic. Thanks. Go DUG (I'll keep adding)
    Reply | Link to Comment
  •  
    May 23 09:19 AM
    www.ft.com/cms/s/0/571...

    uh oh.......
    Reply | Link to Comment
  •  
    May 23 09:32 AM
    Good charts. They show how bubbles pop sooner or later. The Black Swan says no one can predict prices. But bubbles pop. And despite the desperate longs, we have a bubble.

    It's always interesting to see how people who or long or short a stock or commodity leave their brains at the door. They're like directors of not-for-profit organizations.

    No matter how deeply invested you may be in a trade or an idea, you've got to be able to step back and look at the situation objectively, or you'll lose your shirt. Some people never learn.

    At this point, the bulls are focused on what they see as a limited supply of oil. They may be right.

    But price also affects demand.

    And demand doesn't have to go down to prick the oil bubble.

    All that needs to happen is a shift in expectations.

    Once the markets decide that consumption will be contained by price, prices will drop. The bubble will be pricked.

    Are we at that point? The markets aren't saying so yet, but the growing commentary by bubble skeptics suggests that perceptions are changing and the adults may be gaining a hearing.
    Reply | Link to Comment
  •  
    May 23 09:42 AM
    In a static model, oil prices remain fairly static.

    In a world where the population increases yearly, and the growth of oil hog middle classes is skyrocketing, consumpion of a finite (please note that word) resource increases. So tell me again how a finite resource, which has between 25 and 65 years of life is overpriced. If it were water, and we were running out, what would you say?
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