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Recent Oil Spike: 'Irrational Exuberance'?

by: Grace Cheng May 22, 2008 | about stocks: DBE / DBO / OIL / UCR / UHN / USL / USO    

Grace Cheng

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Many banks and investment firms have come out to defend the rise in oil prices, saying that it is based on fundamentals and that prices could rise much further. While they go on saying this and prices move upward, open interest in crude futures contracts has been moving steadily downward since a high of 1.58 million last July to 1.36 million now.

What’s more, in the recent oil spike, open interest actually fell 8% in a week as oil moved up over 2.6%. Could this be a sign of a short squeeze, with small traders who had shorted oil closing their positions as major banks like Goldman Sachs (GS) predict oil will continue higher? Some might even think it was major banks tripping short stops so that they could exit their long positions at better prices.

But aren’t there fundamental reasons for this rise in oil prices? In some ways yes, demand from China and India is increasing, but at a slower pace than oil has gone up. In markets such as the US, gasoline prices have not moved up nearly as much as crude, squeezing refineries margins, and slowing their orders of crude, which shows that demand for gasoline isn’t justifying higher prices.

So could this recent rally be a short squeeze so that banks and funds can exit their long positions while small speculators are filled with “irrational exuberance” over the price of oil? OPEC ministers might think so, they’ve said that the recent spike is caused by speculation rather than by an increase in demand and that their level of supply is more than sufficient. John Hofmeister, president of Shell Oil said that the “proper” range for oil should be somewhere between $35-$90 a barrel.

Meanwhile, those holding the bag of the last big bubble - housing - won’t be too happy to hear that home prices posted their biggest quarterly decline since the government started tracking them 17 years ago. The housing market is suffering from a double whammy of record foreclosures and a huge amount of real estate inventory left over from the boom days.

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This article has 22 comments:

  •  
    May 22 01:38 PM
    Good observation, but I think is important to mention that the price of oil is pegged with the dollar. The recent decline in the dollar, has also fuel higher oil prices. If the price of oil was adjusted for the decline in the currency, I wouldnt be surprise to see that the value would adjust close to the $100
    Reply
  •  
    May 22 01:43 PM
    Your comment about fundamentals and India and China implies that an x percent increase in demand should bring about a linear rise in prices - x percent, or 2x percent, something nice and manageable.

    But basic supply/demand theory says otherwise. When demand exceeds supply, prices don't necessarily rise in smooth proportion to demand. Prices are set at the margin, the last willing buyer, which means the price rises until just enough people say "nah, I don't want it at that price."

    The real question is, has demand finally exceeded supply? If so then prices can spike in an econ 101 textbook manner, without any irrational exuberance. Nobody knows for sure, but we have 3 years of flat supply + growing demand, plus a price spike consistent with this situation. Why invoke irrationality when there is a simple rational explanation consistent with the facts?
    Reply
  •  
    May 22 01:53 PM
    Well, if this turns out to be yet another bubble, it is the wrong one at the wrong time.
    Reply
  •  
    May 22 02:18 PM
    Well, those stimulus checks are arriving in the mailboxes.

    Maybe it's the irrational exuberance of people cashing them in to fill up their tanks--thus, creating an abnormally high demand for OIL.

    Reply
  •  
    May 22 02:28 PM
    "Many banks and investment firms have come out to defend the rise in oil prices, saying that it is based on fundamentals and that prices could rise much further."

    investment banks say and do nothing that is contrary to their interests. why would anyone give a damn what they say or think?
    Reply
  •  
    May 22 03:07 PM
    There is a considerable amount of speculation, if not in oil itself, as to whether or not the current spike signals the beginning of a mania or a bubble.
    There is little or nothing that I have come across that deals with the impact on the American and global economy and markets on the bursting of such a bubble, if it is one.
    Reply
  •  
    May 22 03:33 PM
    recent oil spikes are most likely the result of massive portfolio allocation moves by large pension funds and other large institutional investors.
    there is a great article here on sa referring to an outstanding presentation before the senate homeland security committee:

    seekingalpha.com/artic...
    Reply
  •  
    May 22 03:42 PM
    I'm not so sure the bubble will burst until we collectively do more to slow consumption. Supply and demand can be irrational of one another if their are outside influences that can impact either ie: no one really sees China or India slowing in growth in the short term [hence if supply were to tick up - there would be a home for it] With no way of replenishing oil there's no way for it to recede unless new sources are found - even then you have to look at the higher cost associated with
    tapping into it. Face it - the world economy has some real soul searching to do to negate a dwindling natural resource. Add to this the fact that OPEC has no incentive to curtail rising prices until it adverserly
    effects buying - right now - there's no incentive for them.

    I would like to see how the market would react if we were to discontinue the speculative trading of oil [if it's even possible]
    Reply
  •  
    May 22 04:56 PM
    ALLIED SCIENCE, INCORPORATED
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    alliedscience.org Telephone: 775-727-0866 E-mail: grhudlow@yahoo.com


    Form Project Summary

    Project Name:


    General Introduction:
    Grant Hudlow FOUNDER,CEO
    One person can make a difference, has been the driving philosophy for the life of Grant Hudlow. It was this mind set that led to the birth of Allied Science, Incorporated in 1989. Now, nearly two decades later, with a financial commitments base exceeding $7.5 billion, Allied Science, Incorporated carries it’s message of wholesome, values- oriented products across the United States, Canada, and Europe.
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    Mr. Hudlow enjoys assisting young people in ther entrepreneurial aspirations as well as working with and training school teachers and other professionals. His professional accomplishments and community service have been recognized by local churches and local civic organizations.
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    Elko City Council, Phenol brokers all around the world, Economic developers all around the world, BISNIS, USDOC, USDA, US EX-IM Bank, University of Nebraska, Lincoln, UNLV, UNR

    3. Funding Request:
    $70,000,000 to buy $100,000,000,000 of coal on the surface (that can be mined for $.85 a ton) plus $100,000,000 to build, debug and operate a factory that makes $2,000,000 a day by converting coal to 100,000 barrels a day of gasoline and diesel that sells for $.55 a gallon wholesale.

    Term:
    First tranche: $170,000,000 (to buy the coal $70,000,000; to get environmental permits $7,000,000 engineering fee: to buy the equipment $32,500,000; to build the plant $25,000,000 labor and $15,000,000 contractors fee; to debug $8,200,000; operating cost to profitability $12,300,000.

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    With the allied Science,Inc. facilities, there is NO burning, therefore NO smoke stacks. NO smoke stack means No air pollution. The residuals are distilled water, which is evaporated, and an ash which is stored and conditioned for one year and is used as a non-toxic powder to strengthen roads, make 19,000 lbs. concrete, and for strengthening wallboard.

    Specific Performance:
    From funding, Three months to buy the coal ; Two months to get environmental permits ; Three months to buy the equipment ; Six months to build the plant; Two months to debug ; Three months to profitability.

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    Supporting Documents:
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    10. Letter of Introduction from Bank available at later date.
    Reply
  •  
    May 22 10:18 PM
    Yesterday I wrote a blog warning about the bubble and that will burst sooner or later as all bubbles do. I think this is a bad time to get into energy stocks or futures unless you're a successful scalper and day trader. There are just too may spiky charts out there.

    At the same time that there seems to be more than enough physical oil around, the government comes out with a report on lower inventories. A new report says supplies are and will be tighter than thought. The FT reports that emerging countries finally are reducing subsidies on gasoline, which will make their consumers more price sensitive and Americans and Europeans are cutting oil consumption enough to make traders take notice.

    The short squeeze idea could mean that the market has topped near term.

    But an article on Reuters that describes how the nature of the petroleum futures markets have changed in the last couple of years is the most interesting. To me, it suggests that the futures markets may be doing a lousy job of price finding, at least temporarily.

    And I think trading Dec '16 futures is crazy.
    Reply
  •  
    May 22 11:06 PM
    <I>"John Hofmeister, president of Shell Oil said that the “proper” range for oil should be somewhere between $35-$90 a barrel.</I>

    He said this to whom, in response to what question? Can you provide any context for this quote? I assume it came from the Senate Judiciary Committee Hearing yesterday, but I'm having a devil of a time finding a transcript of that hearing. Please post a link with the full question and answer if you have it. Thanks.
    Reply
  •  
    May 22 11:45 PM
    The head of XOM and other major oil corporations have also voiced their opinions that oil is mispriced and should fall into the $40-80 range. Why do you think XOM has been putting all their cash to work buying back shares instead of exploring at these prices. There is an enormous amount of money to be made in oil on the way up and back down again. The recent pricing mania is not rational based on the real supply data and the current demand. There are a lot of huge players behind the scene at work here much larger than Mr. Boone Pickens. We will probably see some hedge funds get it wrong and go bust like Amaranth did when they miscalculated natty gas. Anyway I tend to agree most with the thesis in the book, A Thousand Barrels a Second: The Coming Oil Break Point and the Challenges Facing an Energy Dependent World by Peter Tertzakian.
    Reply
  •  
    May 22 11:56 PM
    The chances of an oil bubble burst in the short term is about as realistic as Grace Cheng's luscious lips bursting. Despite the fact that gasoline is at 4 dollars per gallon, Americans as a whole aren't really making any significant lifestyle changes. Just as many people this summer are riding in singly occupied gas guzzling SUVs as last year. No significant improvements in mass transit have been made on a national level. No significant number of new nuclear plants have been built. What is really funny is that all these companies like Chevron, BP, and Exxon are airing all these television ads that talk about alternative energy sources being developed while the commericial shows little girls running freely in these beautiful grassy fields with blue clear skies and butterflies chasing them and Enya like songs in the background and I feel so warm and fuzzy that I just want to hug myself until I fall asleep in a field of lillies. Give me a break. Oil will be at 200 dollars a barrel in 2 years. You might as well buy these stocks now and get a piece of the action. The dollar will be worthless at least for another 1-2 years, so you can still ride the bulls for the time being. Until I see Americans carpooling with their neighbors, getting rid of their useless SUVs, voting for more mass transit, etc., then oil will keep climbing. Quit blaming it on China and India. The USA is still number one in oil consumption.
    Reply
  •  
    May 23 12:16 AM
    dave in hackensack:

    here is a link to the prepared testimony of the president of shell oil:

    judiciary.senate.gov/p...

    following is a link to a news story about his testimony. i believe the $35-$60 oil remark was not part of his prepared testimony but was in a Q&A.

    www.mcclatchydc.com/ho...
    Reply
  •  
    May 23 01:00 AM
    icandoitdon,

    Thanks. I had found his prepared testimony already (which is worth reading), but I hadn't seen any transcript of the Q&A yet. I'd seen the McClatchy story as well. It still makes me wonder what the question and context was. McClatchy's prefacing sentence,

    "Most of the oil chiefs acknowledged that when measured through the prism of a pre-2005 world, today's oil prices should be far lower."

    Doesn't make much sense to me, which is why I have been trying to find a transcript to see what the actual question was.
    Reply
  •  
    May 23 07:36 AM
    Bubbles are caused by a steady rise in prices in anything. The reason is of NO importance. People make up reasons. They are caused by EVERYONE. There is no one who doesnt spectulate. (Lets fill our car tonight--tomorrow it will cost more--This is spectulation and its the smart thing to do)

    What to do? Nothing!! The bubble will soon burst.
    Reply
  •  
    May 23 09:47 AM
    There has been a lot of talk about peak oil. The arabs refused to increase supply. As the BRIC economies grow at parabolic rates, and infrastructure is still based on crude oil rather than alternative energies, I dont see any bubble.
    Reply
  •  
    May 23 09:58 AM
    Grace Cheng:

    Great article. Prices don't have to follow exactly the route you're showing, but they mostly do.

    Certainly, the current oil/energy investing mania reminds me so much of the Y-2-K con and the Dotbomb mania of the late 90s.

    At that time you couldn't convince anyone that the date on a computer had nothing to do with controlling grids at power plants. After Greenspan went before Congress and followed along with this nonsense, people would actually fight you if you told them it was foolish to spend money preparing for an event that wasn't going to happen.

    The Dotbomb mania speculating was going on at the same time. When you told people that the majority of these companies had no real income, no cash on hand, and no business plan, they gave you a blank stare and went out and paid $150 a share for AOL.

    I would ask them, because there was no Google at the time, How are these companies going to get people to go to their web sites? They had no clue and no answer.

    Just as with their preparation for the Y-2-K con, there was no stopping them. The Monday after the first day of 2000 passed and not one negative event happened anywhere in the world, CNN reported that over $700 billion had been spent for nothing.

    At the time I believed as I do now that we're living in the "Age of Technology," and have been since Charles Babbage invented the first computer. I had been heavily invested in tech, but when the propaganda got heavier and heavier as the big houses sent their touts out touting stocks selling at never-before-seen ratios and Jim Cramer said "to buy, buy, buy, and keep buying," I sold everything on March 6, 2000, and have my tickets to prove it.

    Today, I believe we're in a long-term bull market for hard commodities that may last another 12-18 years, but along the way there will be both short and long-term downturns.

    Those will come right after big run ups, just as we've had most recently. Markets are inherently irrational, and what's going on right now in the energy sector is definitely irrational.

    Now clearly, markets can remain irrational much longer than reasoning people can imagine, but the longer they run up the harder and faster they fall down; and the more people get hurt by the crash.

    The same thing is going to happen in this current oil-buying boom. I think it will happen fairly soon—perhaps over the next thirty days.

    And as the great Joseph Schumpeter taught us, "The bigger the boom, the bigger the bust."

    Those of you who're irreversible oil bulls should at least get ready to bail out as soon as prices start to turn. But I really doubt if many will, for the past tends to repeat itself when it comes to manias such as this one.

    Rebeldog
    Reply
  •  
    May 23 01:13 PM
    Trilby Lundberg has been saying for years that gasoline is about to peak and then drop off. We'll see.
    Reply
  •  
    May 23 01:35 PM
    Only one short comment on 'peak oil'! We're about half-way through the cheap oil available on earth. The major producing fields are in declining production becuase they are recovering the last, hard-to-get bit. There is ever-increasing demand. Since our economies are almost totally dependent on oil-based energy for transportation and other necessities, we must pay whatever is asked.

    This is not a bubble like others - oil is a finite, non-renewing resource.

    I see the price doubling every year or two.
    Reply
  •  
    May 23 03:16 PM
    i believe its a bubble or at least nearby
    Reply
  •  
    May 23 10:04 PM
    daveinhackensack:

    "Most of the oil chiefs acknowledged that when measured through the prism of a pre-2005 world, today's oil prices should be far lower."

    this was confusing to me too...it suggests to me that he's as confused as anyone why we've seen the magnitude of the current price surge.
    Reply
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