Oil Market Has Probably Over-Reacted to Circumstances

Has oil finally topped out?

Yesterday, the price fell another $4 – to $136. Still, of course, not far from its all-time high. But sliding...

“Oil is a bubble ready to pop,” say some analysts. “No, oil is merely responding to supply and demand,” say others.

What’s the real story?

As usual, you can count on us, here at The Daily Reckoning, to give it to you -- straight, unvarnished and unmitigated.

Trouble is, the real world always has a bend to it. Everything has a lacquer on it. And mitigations are everywhere.

In the oil market, we see both a bubble...and a useful commodity responding to economic forces. If you want to see a “pure bubble,” you have to look at something like the tulip mania in Holland or the Mississippi affair in France or the dot.com debacle in New York. These were “pure” bubbles because neither tulips, nor shares in the Mississippi company, nor dot.coms had any real economic value. Their prices were based 100% on speculation – not supply and demand. And since there was no “there there,” as Virginia Woolf might say, there was nothing left when the speculation disappeared. Their prices could go to zero, in other words.

Will the price of oil go to zero? No...not a chance. If the oil market is in a bubble, at least it is a bubble mitigated by three very important circumstances: 1) oil is perhaps the world’s most useful commodity, 2) more and more people want the stuff, 3) it is priced mostly in dollars whose value, in terms of everything else, is going down.

Normally, we can set aside the first two circumstances. Everyone knows oil is useful. Everyone knows the Chinese, the Indians and all the other foreigners are becoming addicted to it – just as Americans have been addicted for the last 50 years. These circumstances come as no surprise to anyone...and markets can sort them out. They were obvious in the oil market two years ago...they are obvious now.

Of course, even if they are obvious doesn’t mean investors have noticed. And in today’s oil market, it looks as if investors are suddenly waking up to something they should have seen a long time ago. But we suspect that the real surprise to most investors is the third circumstance. During the last 15 years – a period known as the Great Moderation – it was inflation that seemed to be taking a long nap. The band was playing loud music. Free drinks were passed around. Everyone was there – except inflation. Maybe it was out of town, some wondered. Or, maybe it was dead. Whatever happened to it, inflation was not around.

But, then the old party pooper showed up – and people began looking for their hats and saying goodbye to each other.

“US consumer prices up most in 26 years,” was yesterday’s most telling headline. Even the Wall Street Journal announced a price increase – to $2 an issue.

If you’re an oil sheik whose only asset is $100 billion worth of oil under the desert sand, you pay attention. The dollar has lost about 25% of its purchasing power – depending on how you measure it – in the last 5 years. If inflation rates just stay the same, the poor oil sheik stands to lose more than $25 billion by 2013. If he doesn’t think he’s getting a fair deal at today’s oil price, he’s likely to put a little crimp in the oil pipeline – reducing production until the price increases.

On the other hand, if the price of oil goes up enough, he’s likely to think that he should get it while the gettin’s good. Then, he would increase production – driving down the oil price.

Our guess is that the oil market has probably over-reacted to circumstances. When investors realized how much demand was increasing...they bid up prices. And when they realized how much inflation was increasing...they bid up prices further. And when speculators saw prices rising so much, they bid them up even further.

Now, oil is probably ready for a correction. Ten years ago, an ounce of gold would buy about 10 barrels of oil. Today, it buys only about 7. As is the case with oil, gold has responded to the increase in inflation rates. As to everything else, it is probably indifferent. So, if we were just adjusting the oil price to inflation, it should probably sell for about $95 a barrel.

As to the forces of supply and demand – Mr. Market would know better than we do. But Mr. Market, for all his sage experience, has a tendency to over-react. He probably over-reacted to growing, worldwide demand. Now, growth rates are declining throughout the world; he will probably over-react to that too.

So, where will the price of oil go? We wish we could tell you. It might very well sink below $100. But it will never sink as low as a busted dot.com or a crushed tulip bulb.

Even if the price of oil does drop, the U.S. has gotten the message: the time to find what will power the ‘car of the future’ is now.

“The coal revolution is here,” Byron King tells us. “It's always been cheap and plentiful. Now it's going to be clean, and soon it will even be liquid. It's also going to cause a massive shift in world power. Two American companies will profit big time.”

*** The stock market seemed to delight in oil’s slippage yesterday. After weeks of falling prices and gloom on Wall Street, investors were ready for a little fun. So the Dow went up 276. Even the financials started tapping their toes.

The dollar managed a feeble improvement too; after hitting a new all-time low against the euro this week, it rose to $1.58.

And gold? Mr. Spoilsport lost $16, to end the day at $962.

Bill Bonner
The Daily Reckoning Australia

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