Sunday, June 08, 2008

The Explosive Oil Bubble

Future’s contracts take the risk out of changing prices for both the buyer and the seller. A gold producer with a cost of production per ounce of $600 needs a guarantee that they can meet payroll, insure a profit and stay in business. A circuit board manufacture in selling product must buy gold for production at a known cost so they can deliver the product at a predetermined price. Used properly, the futures exchanges take the risk out production.

The price of oil has a very direct impact on the major airlines. They buy jet fuel futures out a couple of years, to lock in fuel costs. This very quick doubling in the price of oil since August of last year has pretty much killed the futures market for the airlines. I am suggesting that they don’t dare to commit to the higher prices long term (I could be wrong). Their ticket prices are locked to their fuel prices. The Airlines are buying spot hoping the prices will come down. It’s kind of like buying Mayonnaise. You buy two for $5 on sale (when you don’t need them); otherwise the spot price is $5 per jar. Remember when California utilities went from contract gas to spot, because spot gas was so cheap? Well, spot gas went through the roof. Hmmmmm

There is nothing illegal going on with the commodities markets. The margin requirements are the problem, they are way too low. Six percent margin encourages speculation. Hedge funds can be rather big players. Plus they are not government regulated. 16 to 1 leverage on commodities futures is a pretty good return. It’s my contention that oil has gone so high that no one is buying futures to lock in a price. Futures are being bought and sold, but only by speculators, producers and refiners. The futures buyer that needs product is only buying on the spot market in the hopes the market drops to a more reasonable level.

Two things are happening, everyone is consuming less oil and anyone with production capacity is bringing it on line. When an airline takes out of service 100 jets, that’s about 3 to 6 million gallons of jet fuel per day not being burned (a 747 holds 64,000 gallons--$256,000). Product for delivery is going to increase. Just with any bubble, there is that final surge before it pops.

The price of crude oil has gone up $15 in two days. It’s reminiscent of the housing fiasco. We can all get rich. Remember the two Bear Stearns hedge funds that collapsed last July? Leverage was the contributing factor. It exposed the real estate mess and it’s been downhill ever since.

What happened in the 1930’s to bring this country to its knees was not illegal. The investment trusts of that time, are our hedge funds of today. They were financed differently, but make no mistake, the leverage was the same. It was 10% margin in 1929. In today’s world, we have 6% or less--we know what we are doing, (and they didn’t?). Yea right!

Goldman Sachs and Company in 1929 had close to one billion dollars of securities in three investment trusts; Goldman Sachs Trading Corporation, Shenandoah Corporation and Blue Ridge Corporation. They were the “Bear Stearns” of their day. All three by 1932 were worthless. [Note: $15 dollars would pay the rent for a month in 1929, in today's money that billion lost, would be equivelent to 100 billion dollars]

The present status of the oil supply it is not easy to calculate. Storage facilities for the US are known, for the rest of the world, they are unknown. There are so many different oil producers, that total production is only a guesstimate. At some point in time with the economy going into recession and with most of the major airlines facing bankruptcy, we are going to have more oil than we can ever use.

The futures market is a ticking time bomb. If oil drops $40, it could turn into a catastrophe. The hedge funds would plunge into the abyss taking with them the banks. Congress could dust off the Glass-Steagall Act of 1933. It kept us out of trouble for some 65 years only to be repealed in 1999.

Bernanke is a little like the Sorcerer's Apprentice in Fantasia. You don't need to buy a ticket to this one; it's more than a movie!


Anonymous said...


Still enjoy your writing very much. Where are all of your usual followers? No comments is unusual. Keep up the good work!

Anonymous said...

by the way Jim, the top management at CALPERs quit a week ago. What you have been saying about pension funds being half empty is probably correct.

Unknown said...

What I find real interesting is this market action that's been going on. Stocks are still above what they were in Feb-March but the companies are doing worse than they were even at those lows. I think rather than a straight shot down like in the 30's were going to see constant "turbulance", raising and lowering of everything until all the speculators are bankrupt. I've finally just dropped my 401K to 1%, and hopefully my company matching covers any losses.

Jim in San Marcos said...

Hi Dan

Traffic does seem to be down a tad. Plus about 1/3 of my links don't publish much any more. Any blog dealing with the housing bubble has been there and done that. We are getting to the end.

There usually aren't very many comments. I have the time to answer the few that there are. Some blogs have 100 to 200 comments and I doubt if many ever get read.

If you scroll to the end of my blog, you can click on the site meter and check how things are going.

Thank you for the ata boy, take care.

Jim in San Marcos said...

Hi Anon 12:40

I missed reading about any rats jumping ship. But todays paper does touch on the land deal (swindle) that CALPERs got sucked into. Looks like a billion dollar loss. Somebody had a real senior moment on that one. The finders fee on that deal must have been real sweet.

This could get interesting when the baby boomers start to seriously tap into the fund.

Jim in San Marcos said...

Hi Ltrand

I think that the market has less than 6 months to live. I could be wrong, but nothing is behaving in a normal manner.

One question bothers me on retirement funds. If a fund was to go bankrupt, how would the contributers be paid off? Would you be paid according to what you had it invested in, or would you be paid according to how much you had in the fund? It probably doesn't matter, the lawyers get their slice first, and then we will get ours (if we live long enough).

Thank you for your comments

Anonymous said...

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Anonymous said...

Jim wrote:

"I think that the market has less than 6 months to live. I could be wrong, but nothing is behaving in a normal manner."

How far do you think the market can drop?

Anonymous said...

I say it will dip down to the lowly range of 8 or 9 thousand or so

Jim in San Marcos said...

Hi Anon 9:50

Your Link didn't fully transfer in the blog remarks. I HTML'ed the link and it should send you there. I really can't believe that the energy department would make such a claim. $4 a gallon gas will ruin the economy.

It's going to suck when the Police department, fire department and other government organizations have to cut back on gasoline consumption.

We the people get to pay that gas bill also.

Bear in mind that doesn't mean that I am right and they are wrong. The picture they are suggesting is pretty bleak.

It doesn't really matter where the money goes to that we are spending, gas or taxes. We as consumers have less for everything else.

We are the only country in the world that can support $4 gas, and I don't figure that will be for very long.

Thank you for the link

Jim in San Marcos said...

Hi Anon 1:31 and 2:29

I'm not sure how far the market may drop. I could see stocks dropping about 50% but in terms of the DJIA average, that would be very misleading.

If you were to examine the 600 point drop in the DJIA over the last 2 days, the divisor of .1228 indicates that the actual DOW 30 stocks only dropped 73.68 points. Divide that by the 30 industrials and you get an individual share drop of $2.50. Nothing really to write home about.

If this sounds confusing, I have a previous article on it that might fill in the blanks.

If you bought your stocks when the DJIA was created, then the up and down motion gives you your relative standing. The trouble is, there isn't anyone alive that bought stocks then that need to relate to that absurd index. But when it goes up, it does give you the warm and fuzzy feeling that you are making money.

Realistically, a 50% drop in the value of the stocks in the DJIA could result in a DJIA of around 6000. If we were to retrace 1929 I would expect to see a DJIA of around 1500. The reason for such a low number, is that people would still play the market at 6000, but at 1500 they would walk away. That's just what happened in the 1930's.

Hope this doesn't scare you too much, it's kind of a worst case scenario, thank you both for your posts.

Anonymous said...

also, I read somewhere that each CALPERs employee has 140K if you divide the total 255 billion assets by the number of employees. After losses, the $$$ per person is probably less than half of that.

so if you take them at their word that they still hold 255 billion in assets, at 140K per retiree, there is no way to payout their promises in todays inflation infested world.

CALSTRS, the teachers fund, is doing a lot better, so I guess they will be looted next.

all I know is that a lot of people counting on a retirement through a pension plan are going to be very surprised that they have been salivating over a false feast.

anon 12:40

Anonymous said...

OPEC questions high oil prices... "(OPEC) reconfirms the view that current price levels do not reflect supply and demand realities."


Jim in San Marcos said...

Hi Anon 5:47

That link did not post well. I tracked it down. Here is the Article

It does leave room for thought and if you pause long enough to really think it over, gas at $5 a gallon will ruin the economy.

Once that happens, you have you will have $2 dollar gas. But you need a job and some money to buy it. Kind of a catch 22

Jim in San Marcos said...

Hi Anon 2:06

I think that a lot of what retirement revolves around is not the money in the account but rather the monthly payment.

This is the part of their retirement that is going to get sick. I don't think that it will be pretty.

I think that you are right, they are about to get the shock of their life. The trouble is, that shock is still several years out.

Thank you for your comments

-Fifty7- said...

Hi Jim,

I've been reading your blog for about a year now and want to say that it has been very informative! Good work!

As far as this whole run up in oil've stated that it is a bubble more or less. Correct? Is it possible that along with speculation in pricing that the supply and demand are real? I've read alot of conflicting stories, etc. saying that we are at the world's "peak" oil supply right now and that demand is rapidlly growing especially in places like China, India, etc. I've also read some alarming data that suggests that the world could run short of oil in the next 20-25 years depending on population growth and increasing world demand year over year. What are your thought's on this? I really don't know what to think or who to believe but if this is true, we have alot bigger problems coming than housing, recession, etc. I can across a few site one being check it out ............pretty scary stuff. Anyway keep up the good work!

Jim in San Marcos said...

Hi Fifty7

Here is a link to some material on the Canadian oil reserves. Further into the link, they get into the cost of production for Saudi oil of about $1 per barrel and about $40 for the Canadian heavy bitumen.

Money is the name of the game and we are going to get a lot of supply at these prices. It will take a year or two for it to come on line.

I went to that site you suggested He raises some good points but I think that mankind has a couple hundred more years to go.

The thing that most people overlook is the earnings per capita for each country. Your not going to be a large energy consumer if your take home pay per year is only $500. Their choice is food or oil. So we get the oil.

It does pay to keep an open mind on this, Congress could start the presses and we could all be millionaires.

I'm glad you like the column. Thank you for your comments.

Hard Money Lenders Direct in California said...

I don't know how long this thing will last, do you know?