Monday, June 02, 2008

Crude Oil Bubble Trouble Part II

Bubbles don’t wave red flags and are not considered bubbles until they pop. They are usually touted as tremendous investment vehicles. A bubble has many things going for it. Low financing costs and high returns with little (perceived) risk and a lot of participation. The stock market crash of 1929 was done on 10% margin. The housing collapse of the late 1920’s was done with 5 year interest only loans, as was our current housing bubble.

Common sense has to come into play sooner or later. Remember all of the lame excuses why housing prices would continue to increase? We have unoccupied half million dollar houses all over San Marcos with burned out lawns. I guess rich people don’t like to live here anymore.

Four dollar a gallon gasoline? How long can it last? Congress can get us to four dollar gas the old fashion way, but this is way too sudden. With oil at $131 a barrel, The world's largest known oil field becomes economically feasible. The Athabasca Oil Sands reserve of Canada will come on line. The trouble is, it could take about 3 years. By that time oil could be back to $60.

Even though we consume a little more than 1/4th of the world’s oil, we can afford to pay the price. The rest of the world cannot, they're already broke. Pundits point to the gas subsides by third world governments. It matters little, whether it is the government or the consumer who pays. It’s one and the same person. Of course 90 percent of the people in this country have a complete disconnect when it comes to government spending and the tax base it is drawn from. It's a little like free government health care, nobody has to pay for it (there’s a wink and a nod in there somewhere).

With spot oil at $131 a barrel and the futures three months out at $127, just buying 10 forward contracts with 100K (6% margin) you have the chance to double your investment over the span of a year. There is a hell of a risk, but no more so than buying a million dollar McMansion (interest only). The oil market could go south real quick. The imminent collapse of our major airlines could do it. The speculator with 10 futures would not be able to make the margin call. What that could do to the commodities market leaves one room to pause.

Just maybe the Chicago Board of Trade is FDIC insured. I haven’t heard anything to that effect but I’m sure Bernanke knows.

Gas will be back to $2 soon. You don't need as much once you lose your job.


Anonymous said...

"Gas will be back to $2 soon. You don't need as much once you lose your job."

That's the whole problem with limited oil supply, we either have a good economy and too much useage for the limted world supply or a crappy economy with no jobs to burn gas driving to. We need to increase domestic production and gain jobs AND energy. these guys need our support:

Great post by the way, informative and I love those roadrunner cartoons! I added you to my favorites.

Joan Jet

Jim in San Marcos said...

Hi Joan

I agree. Oil futures dropped $3.44 today. A 3.00 dollar drop wipes out the margin reserves. They need $3,440 for each option tomorrow morning at the open to keep in the game. It could prove interesting.

I hope that the artist doesn't mind me using his toons for editorial comment. I like Wylie E Coyote. He has that "can do" attitude that always fails so comically in the end.

I'm glad you liked it. Thank you for the ata boy--it made my day.

Tom Tyro said...

I'm pretty naive, so please bear with me, but is it possible some of the OPEC nations are intentionally driving up the cost of oil in an attempt to crash our economy?
Since oil is traded in USD, the oil producing nations are full of billonaires. Some of them are known to have an agenda against America. They can't really buy anything from us (except maybe weapons or insolvent banks).
Couldn't they be manipulating the price of oil, sort of like the way Regan urged the Saudi's to ramp up production to help crash the Soviets? It seems to me they could manipulate the price by continuously postponing delivery on futures, while also controlling production, and hyper-inflate the oil bubble.

Jim in San Marcos said...

Hi Tom

OPEC is a group of oil producers that try to limit world production and keep oil prices high--the trouble is everyone cheats and pumps more than their quota. If they tried to crash our economy, there goes their allowance.

The problem lies with the futures traders and the hedge funds. The number of futures contracts in play is way out of whack. When you refer to the Commodity Exchanges, it's real contracts. When you deal with hedge funds, you are dealing with synthetic products that mimic the real ones.

My best guess is that several hedge funds bordering on bankruptcy acting together have decided to bet the farm on oil to recoup their losses using the synthetic and real futures together in some convoluted manner.

The last time that the Arabs raised prices, they ended up with less revenue. People stopped consuming. That didn't set too well. When you double the price of something you half the consumption.

Oil was down $2.02 today and in Asia trading right now it's down another 60 cents. Plus the third world countries are dropping their government oil subsidies.

Looks like the oil speculators are going to have to pony up another $3,000 maintenance per contract tomorrow, to stay in the game

Tomorrow could prove interesting

Thank you for your comments

Anonymous said... can I hold on to my SUV?
My neigbhor panicked and sold she is in a sedan with four kids to tow around.

Anonymous said...

Yeah, hold onto that SUV. The price of oil is gonna go down. It should go back to 2 bucks a gallon by 2050 when everyone else in the world is using an alternative source of energy. Then your quaint little gas guzzler will be considered an interesting museum piece. Till then you can live in it when your home is foreclosed.

Anonymous said...

By ADAM SCHRECK, AP Business Writer
1 minute ago

NEW YORK - Oil prices shot up nearly $10 to a new record above $137 a barrel Friday after a Morgan Stanley analyst predicted prices could hit $150 by the Fourth of July. The meteoric surge builds on a huge gain the previous day and sets the stage for the biggest two-day gain in the history of the New York Mercantile Exchange.

It's "bubblicious"

Jim in San Marcos said...

Hi Anon 10:36, 9:35, and 5:54

Anon 5:54 Hold on to the SUV.

I think that Anon 9:35 was kidding about the year 2050--Who knows, my 69 Pontiac lists for around 45K and I only paid $3,000 new for it.

As for Anon 10:36 using the words "bubblicious" It gives me a sense of comfort that the ridiculousness of the present oil price fiasco isn't entirely in my mind alone.

I believe we have a bubble here as just like housing. I've got more on this that will probably publish tomorrow dealing with oil and the airlines

Thank you all for your comments

Anonymous said...

Jim, I think the oil bubble is a bit more bubblicious than the housing market bubble; it's more on the order of the dot-com bubble.

Oil demand is down, storage facilities for crude are filled to the brim, we have a reserve larger now than on January 1.

At least the rising dot-com bubble didn't kill any industries on the way up like oil is. I can't help but think a popped oil market is good for the USA, but I wonder if there's any damage that might be done if it REALLY pops... like goes down to $40 per barrell. Thoughts?

Jim in San Marcos said...

Hi Anon 10:45

I've got a piece to publish tomorrow morning on oil covering this.

I can't find any data suggesting that crude oil facilities are full to the brim with crude or that our reserves are any larger than January.

If you have some good data on this, click the last line in the links column and email it to me. I don't divulge sources. Take care.

NMMM.NU said...

I am new reader and I dont know where you stand. Do you believe Oil is bubble, and will go to $60, or you believe Oil will go to $ 150 - 160 as a new norm?

Jim in San Marcos said...


I consider it a bubble. Ask yourself one question, Can the world afford $120 a barrel oil? The answer is no.

Everything is linked to oil. This will force the world into a recession. Oil consumption will fall. The people in the U.S. can't afford $4 gas. The major airlines could be out of business by next February. Consumption could drop drastically.

If you are an oil producer, a drop in the price of oil(caused by a surplus from lack of consumption) would mean a drop in revenue. Most producers at that point would increase production in order to maintain the current cash flow. More oil production would further drop the price.

You might suggest that every oil producer would cut production and the price would then rise. The trouble is if you cut your production and your neighbor doesn't, then he gets to eat your lunch. The oil producers are addicted to oil dollars.

I believe that the price of oil will ruin the world economy. I hope I'm wrong on this one.

To answer your question, I expect oil to stabilize below $80 per barrel.

Thank you for your comments

Anonymous said...

If you don't mind me asking-
What do you think will precipitate
80$ oil?
war ? depression ? post depression era ?
or a smooth landing correction ?
Thx, Catholic girl

Jim in San Marcos said...

Hi Catholic Girl

I think that $145 a barrel oil will throw us into a depression at ambulance speed. If you don't have a job you can't buy gas. Once it drops back to a more realistic level, there will be no demand. Oil could drop to $25 a barrel. Of course by that time the economy is shot.

Anonymous said...

I think a lot of people are failing to consider the value of the dollar when they state the rest of the world cannot afford $145/bbl oil. Everytime the value of the dollar declines, people with foreign currencies can afford to pay more for oil due to exchange rates.

For example, let's say the going price is $150/bbl. Let's also assume that the exchange rate for US to Canadian dollars was $1 for $1. Now let's say the the value of the dollar were to slip 5%.

In terms of purchasing power, that Canadian is now spending only the equivilant of $142/bbl on oil. Or looking at things another way, the Canadian is still only spending the equivilant of $150/bbl, while the American now has to come up with the equivilant of $157/bbl.

Although this is an extreme example, if the value of the dollar were to slip 30% in next ten years, and other curriencies remained relatively stable compared to each other,this would be like the cost of oil remaining stable for the rest of the world, but the price for Americans going up to over $195/bbl.

Although most of what the author says has roots in reality, everyone needs to remember that there are many, many causes behind the rise of crude prices and that what we are seeing is most likely not simply a bubble.

Jim in San Marcos said...

Hi Anon 6:35

There is a little more to the argument that you are skipping over. The US is 5% of the world population and we consume 25 percent of the worlds energy.

The most important statistic is the per capita income of the rest of the world. Probably 3/4 of the world has less than $1,500 per capita earnings. China comes in at $3,000. The US is at $33,000, so we can afford to buy oil.

Oil wasn't the only thing to go up, food crops went through the roof, so in many nations you might also have to choose between food and fuel. That choice is rather obvious.

It costs about $6 to pump a barrel out of the ground and about $6 a barrel to find and drill for it.

There is nobody waiting in line to buy gas like in the 1970's, so it is the rest of the world that is not consuming oil at these prices.

The bubble aspect is more complex. Let's assume that there is no bubble right now and that prices are real. This price for energy will collapse the world economy. At that point no one needs oil and then the glut of oil on the market will be perceived as a bubble.

On top of that several sources of oil tar in Canada (the largest in the world) become profitable at with oil at $60 per barrel.

Another thing to look at seriously, is the investment aspects of drilling for oil. You are getting zero percent interest in the bank and tremendous tax write offs for oil exploration. Within 3 years we could have a serious glut of oil.

If you can find and produce oil for $11 a barrel and sell it for $150, you have to ask yourself, will I get that price 3 years out when my well goes on line?

I don't think so but you will make money unlike the housing industry bubble.

I belive that gas prices could drop drastically. The United States is the only country that can pay the price, the rest of the world is in a lot of pain.

Thank you for your comments

Anonymous said...

Interesting that no one here has mentioned "peak oil". The cheap oil that costs $11/barrel to find and extract is gone. Most country's oil production is in terminal decline. A strong global economy driving oil demand combined with maxed-out supply, declining $USD, and speculation are the three things behind $147 oil, with speculation being the least important factor of the three.

To get oil back under $80 would require a miraculous new find of oil on the level of the original oil in place in Saudi Arabia (highly unlikely), or a total collapse of the global economy causing tremendous demand destruction.

We have used up roughly half the oil the world will ever produce. The ride down the back side of the Hubbert curve (google it) will be a wild one. Cheap oil drives a robust US economy more than any other single resourse, and cheap oil is history.......

Anonymous said...

"To get oil back under $80 would require a miraculous new find of oil on the level of the original oil in place in Saudi Arabia (highly unlikely), or a total collapse of the global economy causing tremendous demand destruction."

It is very interesting that you said that, considering the recent events (of Mid September to Early October) which have caused oil to fall seems to be similar to the "total collapse" of the global economy.