Thursday, September 01, 2005

a bubble of bubbles?

An important feature of an asset bubble is the lack of awareness of one. The internet bubble was an example. Is it really a bubble if everyone and his grandmother thinks it's a bubble? It's doubtful that the housing run is over, and there is an outside possibility that the housing run has only just started.

Experts disagree on why oil prices go up

- Kathleen Pender
Sunday, August 28, 2005

You can't open a newspaper without reading about the housing bubble, but there's another market that's looking pretty frothy: oil.

Even though the price of West Texas crude has risen this year by almost $23 per barrel, more than 50 percent, you don't hear many people calling it a bubble.

Searching the Factiva news database for the past three months, I found only 55 mentions of an oil bubble, compared with 1,981 references to a housing bubble.

Maybe that's because a lot of energy analysts say the recent spike in oil is being driven almost entirely by fundamentals.

They say that worldwide demand is increasing at a time when there is little excess production capacity. Because it takes many years to bring new production online, there could soon be shortages of petroleum products, especially if there is a supply disruption in one of the major oil-producing countries, many of which are as stable as a two-legged stool.

Their theory: Oil prices won't come down until consumers, especially Americans, reduce their demand. Given that oil prices today are still cheaper, in inflation-adjusted dollars, than they were in the 1970s, prices could go even higher before demand falls.

In March, a team of Goldman Sachs analysts said we might not return to an era of excess capacity like the one we had in the late 1980s and 1990s until the price of crude -- which closed just above $66 on Friday -- stays between $50 and $105 for several years and U.S. gasoline prices top $4 per gallon.

But a separate group of experts says this idea of a looming oil shortage is overblown. Based on fundamentals, they say oil should be trading in the $30- $40 range and anything above that is largely the result of speculators. When they exit the market, prices will fall back to more reasonable levels.

"I don't see how anybody in their right mind can say this is based on fundamentals," says Kyle Cooper, an energy analyst with Citigroup Global Markets in Houston.

Who's right? Only time will tell. Here's a look at the arguments.

The bulls: There is no question that oil consumption has increased faster than oil companies can bring it out of the ground and turn it into gasoline, heating oil, diesel fuel and other products.

Between 2003 and 2004, world oil demand increased by 3.2 percent, more than twice the normal annual growth rate of around 1.5 percent, says Jonathan Cogan, an expert with the Energy Information Administration. Much of that new demand has come from the United States, the world's largest oil consumer, and fast-growing China, which now ranks No. 2.

"Growing demand is pushing up against stable production capacity," says Cogan. "There is no excess capacity anywhere but Saudi Arabia. Now we are sort of operating at capacity. It makes any uncertainty about political or other turmoil magnified. That uncertainty does get factored into the price."

The Goldman Sachs team created a stir in March when it published its report predicting a "super spike" in oil prices to $105 per barrel. At that time, oil was in the mid-$50s, and the team, led by Arjun Murti, wrote, "We believe oil markets may have entered a super-spike period, a multi-year trading band of oil prices high enough to meaningfully reduce energy consumption and re-create a spare capacity cushion, only after which will lower energy prices return."

The team noted four fundamental reasons for the increase in West Texas Intermediate crude, the light-sweet oil best for making gasoline:

-- It's costing more to find and pump oil, due to geologic maturity in many oil-producing regions, along with rising service and materials inflation. Figuring that these forces will increase the long-term cost of production, hedgers and speculators have bid up the price of long-dated futures contracts (for oil deliveries in five or six years). That, in turn, has increased the price of shorter-term contracts and the spot price of oil.

-- The price of light-sweet crude oils is growing faster than the price of heavy-sour grades, which are prevalent in the Middle East, "due to high and rising (Organization of the Petroleum Exporting Countries) production volumes, limited complex refining capacity and increasingly strict sulfur specifications in the U.S. and Europe."

-- Significant increases in energy efficiency since the 1980s have allowed world economies to withstand high oil prices more easily.

-- Geopolitical turmoil in key oil exporting countries keeps foreign oil companies from developing resources in a timely manner.

The analysts said that in 1980-81, gasoline spending in the United States averaged 4.5 percent of gross domestic product, 7.2 percent of consumer expenditures and 6.2 percent of disposable income.

Today, gasoline accounts for a much smaller share of income, expenditures and GDP -- roughly 3 percent or less.

"Our new $50-$150 super-spike range perhaps conservatively corresponds to gasoline spending in the United States that reaches 3.6 percent of forecasted GDP, 5.3 percent of consumer expenditures and 5 percent of personal disposable income. If we were to assume that gasoline spending needs to reach the highs of the 1970s, our upside super-spike estimate would be $135," the report says.

It added that gasoline would need to reach $4 per gallon before Americans would swap their SUVs for more fuel-efficient cars.

The Goldman authors said that speculation (i.e. hedge fund activity), "has played a negligible role in global oil markets beyond day-to-day trading noise."

Colorado energy consultant Phil Verleger agrees. He says the impact of speculators "is zip. It's too dangerous" to speculate.

He said prices have been driven up somewhat by the entry of pension funds into the market, but they are likely to be long-term investors, not speculators.

He said a recent paper co-authored by Wharton School economist Gary Gorton is encouraging pension funds to diversify into oil and other commodities. It showed that an index of commodities futures could produce returns equal to stocks with slightly less risk.

"The biggest problem we have today is a shortage of refining capacity" because U.S. refiners built no new plants while Detroit was busy rolling out SUVs, Verleger says.

He predicts that if the economy keeps growing, oil prices could reach $80 or $90. "Probably we are going to see $4 gasoline," he says.

The bears: Citigroup's Cooper says the run-up in oil prices "is based on fear of what could happen," not what's happening today.

"During the last 24 months, the world has added over 200 million barrels to petroleum inventories around the globe. How is that supply not keeping up with demand? Demand has grown significantly. Supply has met and exceeded demand by 200 million barrels."

In the United States, inventories of all energy products (excluding the Strategic Petroleum Reserve) were 4 percent higher in mid-August than they were the same time last year, according to the Energy Information Administration.

Gasoline inventories were lower than they were last year, mainly because refiners had switched to making heating oil early in the summer.

Cooper acknowledges that demand has grown and that it has gotten more expensive to produce oil. He says we will probably never see $20 oil again. But on a fundamental basis, it should be trading for $35 to $40.

The difference between that price and today's price, he says, is due largely to speculators.

"I think you had a massive redistribution of financial assets away from stocks, bonds and traditional assets, with an increasing focus on commodities, " he says.

He compares the price of West Texas Intermediate, which has an active futures market, with the price of residual fuel oil, which has no futures market. Residual fuel is what's left from a barrel of oil after gasoline, diesel and jet fuel and other products are made.

Before 2004, residual fuel typically traded at a $3 to $4 discount to oil. Today, it's $20 cheaper.

Cooper attributes the difference to the fact that hedge funds and other speculators can buy futures on oil prices, but not on residual fuel.

He says energy companies are approving projects that are economical if oil is at least $35 per barrel. Those projects, he says, have barely begun to add to the oil supply. If prices stay above $35, the world could be awash in oil.

People predicting $100 oil are ignoring inventories, just as investors ignored price-earnings ratios and other historical relationships during the dot-com days, he says. "Then, PEs didn't matter. Today inventories don't matter. Guess what? PEs do matter."

There is one difference between then and now. For dot-coms, "the entry cost was three college kids and a server. The entrance into the oil market is billions of dollars and a cadre of highly trained people," Cooper says.

Even so, "if inventories continue to rise, it tells you there's a glut, and the hype (about shortages) is not real," he says.


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