Thursday, May 22, 2008

New Era?

The oil market is showing signs of bubble activity. Congress is holding hearings to determine who the bad guys are while ignoring the possibility that they may be part of the problem. The number of articles on peak oil is nearly endless. And now we've got articles about a "new era" in oil:

From the WSJ:

In Oil's New Era, Power Shifts To Countries With Reserves Middle East Consumes More
As U.S. Seeks Security; 'Higher Prices for Years'

From Newsweek:

The rising price of oil could signal a new era of nasty geopolitical fights.

From the International Herald Tribune:

New era of tough times ahead

From an analyst at CIBC:

"Don't think of today's prices as a spike. Don't think of them as a temporary aberration. Think of them as the beginning of a new era."

We've been down this "new era" path before and it never ends well. The chart of crude oil looks suspiciously like the NASDAQ in early 2000 or the Chinese market in late 2007. Prices have "gone vertical":

I don't know where the top is in the crude oil market, but I know a bubble when I see one.

Update: Here's another story that explains some of the recent rise in crude prices. Via the WSJ:

Surging energy prices are wreaking havoc on producers and speculators who made bets on lower oil prices, forcing some to buy oil to exit their positions. That, in turn, is helping push up oil prices.

Producers who long ago struck deals to sell oil in future years are finding they locked in prices at as little as half what oil fetches in today's red-hot market. Some companies are unwinding these deals by buying back their oil contracts.

Other market players, particularly speculators who misjudged the top of the market, are being forced to buy oil futures to close out bad bets. Those who tough it out are often being hit with crushing margin calls, requiring them to pony up more cash because their trade has gone deeper into the red.

Edward Morse, chief energy economist at Lehman Brothers Holdings Inc., said some traders put big money into complex trades in the fall that fell apart when price relationships flip-flopped the last few days. The market is beset by talk that large producers "wanted to unwind their hedges, putting upward pressure on prices."

Many factors are fueling oil's rapid rise besides this financial squeeze. Although demand has eased in the developed world as growth slows, consumption is robust in developing markets. China's stockpiling of oil ahead of the Olympics and use of diesel for power generation during earthquake rescue efforts have played a part in recent spikes.

Big oil consumers such as airlines have become so alarmed by rising costs Wall Street trading officials said some are rushing to buy oil to lock in future costs.

This is typical of bubble behavior. Producers and large consumers are buying not because they have sound fundamental reasons for doing so; they are buying merely because the price is rising. Producers who sold future production at lower prices are now regretting those trades and trying to correct their mistake. Airlines who, unlike Southwest Airlines, failed to hedge at lower prices are now paying through the nose to lock in a price that almost guarantees they will lose money in the future. That is not rational and my guess is that producers and consumers buying at today's prices will find out soon that they've compounded their earlier errors.


Julian said...

So what do we look for as indicators that we're hitting the top of the market?

Joe said...

Well, in a bubble environment there aren't a lot of good indicators except the anecdotal evidence. There are a lot of ways to interpret the futures markets, none of them very reliable. One thing we've seen recently is a big drop in shorts by large speculators in the commitment of traders report. The large speculators (hedge funds) are overwhelmingly long. Commercials are net short. Commercials are not speculators but end users of petroleum, like refiners. If they are short, it implies that they are long too much of the physical commodity and need to hedge their exposure. That doesn't necessarily mean that the price will drop, but at least they feel the need to hedge against such a possibility. On the other hand we have small traders also short. And small traders are small traders for a reason. Whose side do you want to be on?