Wednesday, December 17, 2008 2 comments ++[ CLICK TO COMMENT ]++

Can the free market create an identical bubble from one that just burst?

How likely is it for a recently burst "bubble" to inflate again in a short period of time (on its own without government intervention)? The bubble I'm talking about is none other than the oil bubble.

Let's for the sake of argument, since some still claim oil was not in a bubble, assume that oil was in a bubble whose low was marked in 1998. Commodities are very volatile and I agree with Jim Rogers that 50% corrections are nothing special in commodities. But the current correction is way more than 50% and seems more remniscent of a blow-off. Now, one of the popular arguments made by oil bulls, as well as many leading analysts, is the notion that oil is going to rise rapidly once the world economies start growing faster in the future. Is that likely?

I have been bearish on commodities for a few years and been mostly wrong but still maintain my views for the most part. I don't think many of the commodities are in a bubble at current prices but I am not bullish either.

I bring up this topic because I find it interesting that people think that the free market is going to cause another bubble in the same area right after it bursts. The bullish argument is mainly pinned on the view that capacity reductions and the non-renewable nature of oil will create shortages when the world economy does pick up. Let's ignore the argument that world growth will be lower in the future than the last 10 years (at least that's my view--decline in world trade and decline in leverage seals that IMO.) I wonder, why wouldn't the market--the companies themselves, as well as investors and speculators--price in the future increase? Everyone knows that capacity is being destroyed. So wouldn't the market factor all that into account?

I think the arguments of the bulls make sense if oil is undervalued. Who knows what price indicates oil is undervalued but let's roughly say $22 per barrel (the long term real price of oil over the last 130+ years.) Until prices come somewhere near that, I find it hard to believe that oil can run up past $140 again (note: I'm talking in real terms. If the US$ declines significantly then prices will go up but that's just an illusion.)

For now, I will maintain my slightly bearish view and watch how the oil bulls prosper or fail...

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2 Response to Can the free market create an identical bubble from one that just burst?

December 17, 2008 at 10:08 PM

Great comments on oil. You provide a contrarian view on commodities. I've been interested in oil recently, but more as a hedge against the risk that political instability increases or that technology is not able to supply the world with sufficient energy in the future. I almost pulled the trigger on oil last time it came down to $40 a barrel a week or two ago, but my gut has been telling me to wait for a cheaper price, especially given the global decrease in economic activity. Now I have to figure out who is the lowest cost producer of oil with sufficient reserves and good management. Any ideas?

December 18, 2008 at 10:41 AM

I don't follow oil&gas closely anymore so I don't have too many potential investments at the top of my head.

First of all, you need to decide whether you want to bet on the commodity or the companies that deal in them. It is possible for oil prices to rise while oil stocks don't go anywhere. Or conversely, oil stocks can rise even if oil prices stays flat or declines slightly (this can occur if stocks have been beaten down irrationally.)

If you are interested in the commodity, you can obviously invest in one of the three ETFs that track crude oil.

If you are bullish on oil stocks, I think you can pursue two strategies. One is to go for safety and predictable income that is not as reliant on the oil price. I think this would essentially mean beatting on a supermajor. I haven't looked at the sector closely in the last few years but I would start looking at Petrobras (high government risk but one of the few supermajors with large potential production increase,) Total, or even Buffett's picks such as ConocoPhillips.

The other strategy is to go for the high risk ones that will do really well if oil price goes up. This might seem counter-intuitive but one of the strategies with commodity investing is to go for the high-cost producer. This only works if you are extremely bullish on oil. Companies with high costs have far more leverage to the commodity price so they have far greater profit potential if oil price rises. Examples include companies mostly reliant on oil sands, shale oil, deep sea oil, and the like. A lot of the majors have exposure to the oil sands but a company like Suncor is a pure-play.

If you are really bullish, you can also go for E&P (exploration & production) rather than the integrateds. E&P is obviously highly leveraged to oil prices.

Donald Coxe of BMO, a Canadian commodities superbull, prefers companies with long reserve lives in stable parts of the world. He likes some of the Canadian oil sands companies as well as some American ones that operate in safe parts of the world. I don't keep up with him but, if you are interested in oil, you might want to research what he has said recently (he often lists a bunch of stocks).

If you really want something that is very high risk with huge potential, and you are ok with taking on big political risk, you might want to look at the Russian oil companies such as Lukoil. One company I briefly looked at was SURGUTNEFTEGAZ (SGTZY.PK) which some article said was trading below cash on the books. Most of these companies trade in Europe or on PinkSheets/OTC. My impression is that, if you limit yourself to sizeable companies, the Russian companies are the cheapest oil&gas companies in the world right now (the whole Russian market trades at a P/E of 3 and if their currency is devalued a bit more, it's very cheap for foreigners to acquire assets there.) But Russia has huge political risk and some of these companies look very shady and would be on par with the Chinese or highly corrupt Indian companies. Like the Chinese, Indian, or Japanese companies, you just can't trust the Russian management, which is partly government, to do anything in the shareholder favour.

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