Tuesday, June 17, 2008 0 comments ++[ CLICK TO COMMENT ]++

Is Oil In A Bubble?

Is oil in a bubble? Who knows, but we are certainly entering an unprecedented area. Shown below is a chart of real oil prices stretching back to the late 1800's when oil was commercialized (the first oil well was actually drilled as far back as 347 CE in China, and oil itself was discovered even before that).

(source: Price of Petroleum, wikipedia.org. SVG image downloaded June 17 2008)

The above chart from 1861 to 2007 shows oil in real prices (using 2007 dollars). If I'm not mistaken, given the run up in oil in 2008, oil has actually hit an all-time real peak (for those not familiar, when we say 'real' we mean prices adjusted for inflation). In the super-long-term, real crude oil prices have been flat (somewhere around $25.)

The following is real gasoline prices in the US:

(source: Short-term Outlook, EIA. Image downloaded June 17, 2008.)

Unlike crude oil, note that gasoline prices, like nearly all commodities, have been deflationary over time (at least in USA). They had declined gradually from around $3.00 per gallon in 1919 to $1.50 per gallon in 2003 (all real prices in 2008 dollars I believe). This is one reason commodity businesses are generally poor investments. It doesn't mean you can't make money but it is tough. For instance, there have been many refineries that were shut down in USA over the last 20 years. Ironically, the current high oil prices are squeezing margins at the refiners as well (retail gas stations are also not doing well right now (ExxonMobil is planning to get out of this operation because of low profitability.)) The refiners seem to suffer when oil prices are low; and they seem to suffer when oil prices are high. Even Hell is kinder than that ;)

I can't be certain oil is in a bubble but I think it is. Even if you are bullish and long oil or oil shares, you better have a good justification for the all-time high. There really has to be a paradigm shift of some sort (some oil bulls argue for it*) or else prices are going to come crashing down. Yes, it's not just going to decline but crash. But, if oil is indeed in a bubble, it can go much higher than even a bull expects. Everyone knew that technology stocks were in a bubble in 1999, yet the NASDAQ went up 100% in one year--an amazing feat for a major index with very large market capitalization. Oil is a commodity and oil stocks haven't gone up the same amount but the point is that any asset in a bubble can rise much higher than one thinks.

(* theories cited by oil bulls to justify unprecedented price levels include the peak oil theory, supply shortage due to various political/social/engineering factors, and perpetually high demand growth in key developing countries such as China. I don't buy any of it but that's just me and I have been wrong for more than an year.)

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