The Demise of the Oil Bubble

When I made my $1,000 bet that oil prices wouldn’t reach $100 in 2007, I felt like that was a pretty safe bet. Up until about the first week of September in 2007, it was looking like I was cruising to an easy win. But then oil prices went on an unprecedented run. Prices climbed almost 50% between September and the end of the year, and twice came within a whisker of reaching $100. Then, on the first trading day of 2008, the $100 mark was breeched, and eventually soared to almost $150/bbl in July of 2008. I won the bet, but a lot of people felt like I had really lost, as the point I was trying to make is that oil hadn’t yet peaked – and the price would reflect that.

It wasn’t that I felt like oil wasn’t going to reach $100. I did. But I didn’t think it would happen until year end 2008 or some time in 2009. (See the 3rd graph in Peak Lite Revisited which shows $100 being breeched right at the end of 2008). The main reason for this is that the economy has to have time to adjust to higher prices. What I foresaw was a rise, followed by demand destruction, bankruptcies in various airlines and auto makers, a price correction, and then another rise.

I foresaw a jagged rise – not the exponential rise that we saw over the past year. I felt like the rapid run-up starting in September of 2007 could not be justified purely on the basis of the fundamentals. I had a lot of arguments with people who think peak oil has passed who suggested that I just hadn’t anticipated how quickly things would fall apart. And it was certainly hard to win those arguments when oil prices continued to set records.

For some of those peakers, the present environment of falling prices means election year price manipulation. It could never mean, after all, that prices had indeed gotten ahead of themselves. But the Wall Street Journal weighed in today on the matter of the ‘oil bubble:’

The Official Demise of the Oil Bubble

Like a number of other commodities, oil’s move went from a steady ascent to a vertical bounce in the spring of 2008, topping out near $150 a barrel before speculative excess started to drain from the market. And those who believed that the oil price was justified by fundamentals — being, as it is, an actual product, rather than an Internet company’s vague promise of revenue — are smarting.

“This is a market that is basically returning to the price level of a year ago which it arguably should never have left,” says Tim Evans, energy analyst at Citigroup. “We pumped up a big bubble, expanded it to an impressive dimension, and now it is popped and we have bubble gum in our hair.”

On the other side are analysts who think this is a brief reprieve before oil prices rocket back up (many feel this will happen right after the elections):

Oil to Reach New Highs by Year-End

When oil moves, it moves the index. The sell-off brought oil down from a high of $147 to roughly $90. It bounced back up to $108 to $110; $108.50 is a good support and resistance level for oil today. The next price up should be $112.50, then $122.50, followed by a couple of more increases. I think the top is going to be $150 to $157. That was our forecast.

Charlie Maxwell, in Barron’s, says $300 oil in about five years—that’s the long view. Inflation adjusted, he’s probably right. I think we’re only about halfway into the commodity bull market. Despite the credit problems in the U.S., Asia is not going to be economically buried to the extent that we are. And that’s a continuous growing market for gas and oil.

I disagree with that assessment in the short term, but think the long-term is probably correct. I do see the long-term as still very bullish on oil. But it isn’t a market for the timid, as the current correction is proving. These corrections can be brutal, but as a long-term investor, what I really care about is whether oil prices are going to be much higher 5 years from now. I still think the answer to that question is “Yes.” (However, I do think that Matt Simmons is going to lose his $10,000 bet that oil prices will average over $200 in 2010).

One other thing I believe is that oil company stocks have oversold. I own ConocoPhillips stock, and the PE is currently trading at just over 4. The yield is up to almost 4%. Those are insane numbers for a company that has oil reserves worth more than 10 times the market cap of the company. If I was Jim Mulva, CEO of ConocoPhillips, I would be buying back stock as fast as I could.

I have always said that investor psychology can really play havoc with a portfolio, but in the long run I have to believe that oil company stocks are worth significantly more than current valuations. They are trading as if oil was at $20/bbl, and it isn’t going there. No way. In fact, I still don’t believe it will go below $50, which is a prediction I first made in 2005 (that oil would never drop below $50 again).

14 thoughts on “The Demise of the Oil Bubble”

  1. Total has a P/E of 5 and a dividend over 5%. I think these guys report record revenues again this quarter. Despite the 50% drop in oil,gas and diesel are down less than 20%. They’re minting money at those refineries.

    Even with tar sands production costs of $50 a barrel,the market could still dip under that temporarily. All bets are off on markets and the economy at this point. The world’s financial system is shaking like a rickety building during a strong quake. Even leading experts are clueless on whether it’ll survive.

  2. Didn’t oil drop below $50/bbl some time in 2006? Could fear in the market cause oil to drop below $50/bbl even if the fundamentals don’t call for it?

    I was noticing that the IEA Oil Market Report showed another record high 87.8 mb/d of global oil production in July. You were predicting it would reach 90 mb/d before we hit the absolute peak, right?

    There was some noise from Brazil about increased oil reserves. Is that at all significant? Or is it a drop in the bucket?

  3. I think it is still difficult to pin the blame on speculators, because it is often forgotten that the oil price includes expectation of future demand and supply. So if a recession is now expected, this should lead to lower current price – which is exactly what has happened.

    By the nature of debt driven economic booms, it is inevitable that assets such as stock and commodities will be overbought, and a correction ensues.

    Whatever signal there is in the oil price about PO, it is largely swamped by the wider macroeconomic effects.

  4. As the financial meltdown continues, demand — or at least expectations of demand — will decline. So we have people saying that the upside of the economic crisis is that we’ll have cheap energy. For a while. What most people are missing is that too-cheap energy prices and the financial meltdown are inducing a dry-up of the money needed to finance the development of new oil and gas projects, which isn’t cheap any more. This has serious implications for the future.

  5. Didn’t oil drop below $50/bbl some time in 2006?

    I don’t think so. It got close in early 2007 (traded at $50.51). Here are the historical weekly numbers for WTI (which is the crude I was referring to when I made this prediction in June 2005 to my then boss at ConocoPhillips):

    Historical Spot Prices for WTI

    I wouldn’t be surprised if oil hit an intra-day mark below $50, but if so I am unaware of it. But my prediction was meant to highlight the fact that I think we have entered an era of permanently higher oil prices (where $40 would be considered low).

    RR

  6. The vexing reality of crude on the NYMEX is that it is set by speculators, not the larger market. This is possible as demand and supply for oil are short-term inelastic. The NYMEX price can wander even $100 from the “true” market price. We may see that now: Oil could go down to $47, which will be $100 below the peak.
    So the known recent trading range for oil is $10 to $147.
    However, above $147 we were seeing immediate demand destruction. It is very hard to make a case it can go to $200, let alone anything above that. Consumers and businessess immediately start altering behavior. The car-pool, ride busses, ask for a four-day week.
    Looking ahead, we have now accumulating the longer-term responses: People buying higher mpg cars, moving closer to work, or mass transit. The big truck makers are bring out 18-wheelers that get nearly double the old mileage. Freight is being shifted onto trains.
    It is nearly certainty that the developed world has seen peak demand already, and the figs show declining demand in Europe and the U.S.
    That leaves the Mideast and China. Interesting; If Mideast revenues decline, so will sending there, meaning less demand. At the same time, the screw has turned: Now, to make more money, they have to pump more. Interesting.
    China imports oil, famously so, and is a mercantile nation (and not a democracy). They are heavy in lithium batteries and CTL. Look for growth in demand for imported oil to start levelling out. The middle-class car boom in China may start with EVs. They will nuke up.
    My guess is that the NYMEX price has been gamed, and will be gamed again. Thanks to short-term inelastic demand, and the alignment of interests among financial manipulators/quislings and OPEC, it likely will be gamed north again.
    Look fot TOD hysteria again at some point.
    But for now, huge losses are killing the long speculators, and as they liquidate, there will be even more selling pressure. remember, it is speculators who set the price. The NYMEX price could easily sink below the “true” market value.
    The good news is that north of $147 it hit a wall. Moreover, market reactions have been set into place that will likely drive the price down for years.
    The bad news is that even at, say, $125, it represents a gigantic unwarranted transfer of wealth to thug states.

  7. It is very hard to make a case it can go to $200, let alone anything above that. Consumers and businessess immediately start altering behavior. The car-pool, ride busses, ask for a four-day week.

    True, which is why I think the rise will be jagged. But people will still use oil at $200 or even $400 a barrel. After all, gasoline in the Netherlands this summer traded at $420/bbl (most of that was of course taxes) and cars were still on the roads. So I think oil will get to $200; it’s just a matter of time.

    RR

  8. Natural gas may be better as a long-term investment than oil (obviously, there are many companies that produce both)…it is becoming increasingly difficult to build coal plants, and continues to be very difficult to build nuclear plants. Wind & solar are going to account for only a fraction of load growth. This leaves nat gas as the only realistic option for most incremental electrical generation. Also, some homeowners who still use oil for heating are converting to gas, and in-city transportation (busses, delivery vans, etc) will increasingly be gas-powered.

  9. RR-
    Yes, and there were plenty of cars on the road in Los Angeles at $4 a gallon — but mileage was going down. Down 7.5 percent in one year. Netherlands demand is going down too.
    At $200 a barrel, we would see even larger drops in demand. I always point out a trite truism, but worth repeating: If the average US vehicle increases its mpg by 10 percent, and travels 10 percent fewer miles, you get a 20 percent reduction in demand.
    Ome-fifth of our refineries would have to mothball at that point. And those are not large changes.
    We may see now replay of 1980-1981, when global crude demand fell by 11 percent. That would throw another 8 mbd on the market. Can OPEC cutback that much — as revenues are strained due to lower prices?
    After the 1980 price spike, demand did not recover for 10 years. This time around we have EVs, biofuels. It could be 15 to 20 years before we see 87 mbd of demand again, or maybe never. We may have already seen peak demand.
    Conco may trading trading a low mulitples for a reason. Of course, in a couple more weeks, maybe everything will be trading in single multiples.
    Consider it Bush’s Going Away Party for the nation. Your net worth is cut in half, and farewell.

  10. Remember Econ 101, guys — markets work by over-reacting. Talk about “bubble” misses the point. Prices that are higher — or lower — than the long-term trend are a normal part of the market process.

    Also useful to remember Oil Supply 101 — the world needs to add 3-6 Million Bbl/D of additional production capacity every year just to keep global oil production flat. Adding that amount of new capacity each year is not getting any easier or cheaper.

    Bottom line is what the smart people have been saying for some time about oil prices — Expect Volatility. Which is the jagged part of RR’s jagged price trend.

  11. Exactly right, Kin!

    It is very hard to make a case it can go to $200, let alone anything above that.
    Utter BS, Benny, and you will probably eat those words in the next five years, assuming that the global economy isn’t heading for a major recession.

    As I said all along: a global economic slow-down will give us lower oil prices, only we’d be so freaked out by the collateral damage, that we won’t be celebrating. It came to pass.

    However, above $147 we were seeing immediate demand destruction. It is very hard to make a case it can go to $200, let alone anything above that.
    Immediate, eh? Any data to support that hypothesis?

    People buying higher mpg cars, moving closer to work, or mass transit. The big truck makers are bring out 18-wheelers that get nearly double the old mileage. Freight is being shifted onto trains.
    In July and August your statements about cars were accurate. Lately it seems they’re not selling much of anything. Tight credit will do that. Barring Uncle Sam’s generous bailouts GM, Chrysler and maybe Ford is facing bankrupcy.

    I also doubt that people are moving closer to work: tight credit makes moving around a costly proposal. Of course, I’m also open to conviction by real data, as opposed to dreams in LALA land.

    China imports oil, famously so, and is a mercantile nation (and not a democracy). They are heavy in lithium batteries and CTL. Look for growth in demand for imported oil to start levelling out. The middle-class car boom in China may start with EVs. They will nuke up.
    I see the future of China a little differently. China’s economy is tied at the hip to the US economy. We get a recession, they are going to hurt big time.

    They are investing in a bunch of different technologies. Good for them! DOE, are you guys paying attention? Still drunk on corn ethanol?

    But even China can’t make the EV compete it the technology is not ready.

    And you can’t have it both ways, Benny! If oil prices are going down (as you keep repeating incessantly), China will keep burning it and EVs will have to be developed elsewhere. Judging by past experience, elsewhere does not include the US.

  12. Matt Simmons will certainly lose his $200 oil in 2010 bet. I’ve been ignoring his hysterical predictions for a few years now.

    And as — I guess now former — peak oil spokesman, I would warn all those at The Oil Drum, the Energy Bulletin, in various ASPO organizations, including the one I used to write a weekly column for —

    You can not interpret what is going to happen in a complex, non-linear world by examining a single variable = the oil supply

    If you look at 321energy.com, you’ll see an article I recently wrote that attempts to engage the complexity of the oil markets now and in the medium-term.

    The only comment I received on it via e-mail was by some overly excited doomer quoting 8-10% decline rates in global oil production — he got those from Simmons — who assured me that my gloomy predictions about the oil supply and price after 2010 were not nearly dire enough to suit his taste.

    World can’t end fast enough for some people. Unfortunately, we have an over-supply of simple-minded one-dimensional views of future energy (oil) issues and we have a severe lack of people who are will to take a look at the big picture.

    keep up the good work on this blog, Robert

    Dave Cohen

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