Friday, June 27, 2008

Maybe Oil isn't a Bubble after all

If there's one characteristic that every previous market bubble has exhibited, it is this:

Few people knew it was a bubble until it burst, and by then it was usually too late to avoid large losses.

The two most recent examples were the housing bubble that peaked in 2005, and the tech/stock market bubble that peaked in 2000.

Many of the market "experts" in 1999 and 2000 were convinced that a new era of stock valuation was upon us, and that it made perfect sense for run-of-the-mill large companies to have P/E ratios of 40 or higher, rather than the historical average of 15. Most investors obviously bought into the hype, because people kept buying despite the insane valuations. On the other side, most investors didn't give up on the dream until well into 2001 or 2002, after already suffering huge losses in their investments. Indeed, sell-offs and reduced investor enthusiasm are really one and the same thing, so it's impossible for the majority of investors to avoid the eventual downturn. It's simply a matter of time and how soon the change-of-heart happens.

Similarly, the news in 2005 was not about the coming housing collapse, but rather the amazing non-stop run-up in home prices. Television was loaded with seminars and infomercials touting ways to make large profits with real estate. The realization that it was a bubble gradually dawned only as prices started to fall.

Today there's a great deal of talk about the "oil bubble" ... but that's precisely the problem. If potential speculators think that oil prices are in a bubble, then it means that those speculators are on the sidelines, waiting for prices to come down. If you don't own something, then you can't sell it, and if you can't sell it, then you can't contribute to any price collapse. Bubbles simply don't form when people are expecting a bubble, so the more I hear talk of an oil bubble, the more I fear that it isn't a bubble at all, but rather a real and long-term increase in the price of oil.

There are fundamental reasons for higher prices in this case, and the most obvious is the changing balance between supply and demand. On the demand side, it's no secret that emerging economies around the globe are using more and more energy as they expand and modernize. If the rest of the world were to eventually reach our level of automobile use, then the total oil consumption would be about 5 times what it is today. I can't think of any scenario which would reduce the global need for oil, except perhaps a world-wide economic recession, and even that would only be temporary.

On the supply side, there's little hope of any substantial increase in drilling, pumping, or refining worldwide. OPEC countries are enjoying huge profits right now, and have little incentive to increase production. Oil importers like the United States are strangely reluctant to increase their own supplies, thanks to environmental concerns, distrust of "big oil," and general antipathy towards unsightly energy infrastructure.

So the mathematics of the price of oil is pretty simple: the demand is increasing steadily, and will continue to do so for decades as long as economies are growing, while the supply will remain steady at best. There may be short-term zig-zags in the price due to world events, but in the long run I'd say high prices are here to stay.

2 comments:

Catherine said...

Excellent assessment. Today's WSJ featured this relevant article on the front page, today.

http://online.wsj.com/article/SB121451556299908501.html?mod=todays_us_nonsub_page_one

adventurerneil said...

Jody,

I agree. I'm not sure if we're in "Peak Oil" mode, but the supply and demand both tend to favor longer-term high oil prices.

However, as the US economy saw in the aftermath of the OPEC price manipulations of the 70s (http://en.wikipedia.org/wiki/1973_oil_crisis), the consumer DOES eventually shift consumption down and try to find alternatives. This is known as the second law of demand.

Additionally, there are a great number of developments in alternative technology and more efficient technology for cars and just about every other energy guzzler. When I need some positive news in my life, I always turn to www.ecogeek.org, which showcases corporations and individuals that are working on solutions. While I don't necessarily think our oil economy will be changed tomorrow, I do have high hopes for 10-20 years...