Oil -- The Latest Bubble?

Perhaps I am in denial, but I have mistrusted the surge in oil prices almost from the beginning. To me, the magnitude of the rise in oil prices is as suspicious as the rally in tech stocks in the late 1990's and the rise in home prices since the tech sector crashed.

I understand--and agree with--most of the arguments in favor of rising in oil prices: China has emerged as a huge consumer of oil just as political disruptions have pinched oil supplies. Still, I have a hard time believing that these events justify a 433% increase in prices since the end of 2000 or a 76% surge in the past 12 months. In my view, this rally looks like another bubble.

According to the U.S. Department of Energy, world demand for oil has increased at an average rate of about 1.6% each year for the past 7 years. This is in line with past growth rates (and past estimates of future growth rates) so it can hardly be considered a "surprise development." At the same time, the growth in the supply of oil has slowed slightly from about 1.6% per year to 1.5%. This mismatch in growth rates is certainly grounds for some upward pressure on prices, but it hardly seems to warrant the magnitude of price increases we have experienced.

In my mind, a much more plausible explanation for the rapid rise in oil prices is the increased involvement in this sector by "non-traditional" players such as hedge funds, pension funds, mutual funds and individual speculators. As a group, these investors control trillions of dollars. Even a small allocation into oil by these portfolios would account for tens of billions of dollars of marginal demand for "paper barrels" - a huge influx for a narrow market for commodities like oil. And while the price of a futures contract is usually thought to be a derivative of the spot price of the underlying commodity, the algebra that governs the relationship between the two could just as easily allow the spot price to be driven by the value of a futures contract--at least in the short term.

The chart at the top plots the spot price of oil along side the number of outstanding contracts for oil futures. I think it is telling that they rise in near lockstep with each other. While statisticians would argue that a tight correlation hardly proves a causal relationship, I contend that the strong interrelationship between the two is hardly coincidental.

As with most bubbles, there are plenty of people who refuse to see it. Some think the rising price of oil is a sign of the end of the world as we know it. Others believe it is a product of rising inflation expectations and a falling dollar. Many believe oil is a one-way trade, that it must go up over time. Often, they argue that prices aren't in a bubble because they keep going higher - a circular form of reasoning that seems to defy gravity.

My feelings are just the opposite. After the d0t.com crash and the real estate debacle, I think we should all be a little smarter about bubbles. Bubbles have a tendency to pop and when they do, the bottom can be a long way down.