Is the Oil and Energy Bubble About to Burst?

One of the biggest rallies in oil and energy prices might be nearing the end soon. Oil prices have nearly quadrupled since the beginning of this century due to various well known factors: 9/11, war with Iraq and Afghanistan, tensions with Iran this and North Korea last year, political turmoil with the former French prime-minister, and now with Russia's Putin, uncertainties and decisions of Venezuela's Hugo Chavez, hurricane damages from couple of years ago and Israel-Lebanon conflict from last year - all coupled with the incredible growth of emerging and developing nations.

We should note that oil prices have been fairly flat for many years prior to this bull run. When I say flat, I really mean that its prices have not accurately reflected inflation since seventies, really. All these events from the first paragraph, enormous global economic explosion, incredible fuel demand from growing China and other emerging markets, simply had to reflect on oil prices. But now, with crude reaching for $100 a barrel, one should start being cautious. Here in the US we are still taking these oil prices fairly well, but elsewhere (such as China or Iran) we are already hearing that these high oil prices are slowly starting to create social pressures and increasing tensions turned toward those governments. And stress of that nature could mean that we are nearing a turning point in this "never-ending" energy boom.

We are already seeing some actions that could lead to reducing demand. As we learned in Economy 101, markets always find price equilibriums, and soon we might see some actions that will force reduced demand, increasing supply, and thus lower oil prices. We are hearing from the world's soon-to-be largest economy that there is a definite problem ahead to keep a stable supply with the prices this high. Friday we learned that Chinese government decided to increase domestic gasoline prices by 10% in order to reduce demand, reduce never-ending fuel appetite of its growing economy, and fight the crazing energy market. This move could slow demand, and knowing that most of today's demand growth does come from China, we could foresee a great impact on global oil prices.

As per the Wall Street Journal, inflation adjusted all-time high for oil is $101.80, and oil rose above $96 on Friday. Chinese decision acted as a catapult for further spike on Friday on speculation that demand of Chinese refineries might actually rise now, as it gives them incentives to sell more gasoline now that the prices will be higher. In addition, the oil rally was helped by reports of supply shortage in Beijing, and that situation might be soon worsening. These unrests put a burden on government to do something about it. And in the rest of the world, the situation isn't brighter. There are protests rising throughout Asia, Middle East and other emerging markets. As a matter of fact, we had a similar situation in Iran recently when its government spiked gas prices by 25%, or in Burma where the gasoline prices doubled. All that led to a well-known protests and demonstrations. It's only a matter of time that the large economy of India will do something to curb the demand as well.

The Chinese move, though, is the most significant one. Today's China uses 10% of overall global oil supply. Its move comes as a part of the solution to prevent potential social unrests if oil continues to be high. In addition, recent dramatic increase in crude prices create inflationary pressures and could potentially slow down rising Asian economies, as oil is one of the major components not only for gasoline, but for petroleum used in many of the products created throughout Asia for exports. The McKinsey Global Institute stated that "ending fuel subsidies worldwide would cut demand for transportation fuels by three million barrels a day." Sinopec (SHI), one of the largest Chinese oil producers, has stated that it is under big pressure from the rising crude prices. "We will try the best to ensure a stable supply of fuel in the market, but it's a big challenge for us," Sinopec's CFO stated this week. And Indian oil companies, and its economy overall, could face a serious trouble if the oil prices continue rising, as India imports most of its oil.

In other words, either the economy worldwide (especially in emerging markets) slows down completely because of high prices, thus forcing lower oil prices due to the lower demand, or governments act proactively and increase gasoline prices themselves, thus reducing demand for gas, which would lead to lower consumption demand and with that lower crude prices, in order to continue a stable economic growth. I guess governments are more interested in continuous stable growth than to a screeching economic halt.

So although every oil bull presumes that we will see $100 now, I'd be cautious. Many who already fattened their portfolios with rising crude prices might be already slowly taking profits, anticipating that many will want to off-load at $100 mark. So, the question is will we even reach $100 in this particular rally. Better question might be: who in the world would want to buy crude at $100 now? All would want to cash in at $100, but to continue this rally some would need to keep buying at $100. I don't think there are many who'd like to take that bet that oil will rise further above $100. At least not now. So, oil at $100? Oil at $120? Yes, sure, probably. But maybe not now. Not in this rally. I'd say let it rest a bit, let it retest its support again, because as you know, they (stock, futures, anything) always, sooner or later, re-test their support lines.

Disclosure: Author has a short position in the above-mentioned securities

Comments

[Ernie Montague]

Basically true unless the market says it is not. One serious war in the middle east (Iran, terror bombing of Saudi rigs, etc) and $100 oil will look cheap.

[Beris]

Thank you for reading and for your comments, Ernie. I am sure that one day $100 oil will look cheap, but in my opinion, for this oil bull market to continue it first needs to have a reasonable pullback.

[alpha24seven]

Good article. Saw Tesoro chief on TV the other day say we are swimming in crude. Large amounts of excess capacity and every single day they take calls from suppliers they've never even heard of trying to get them to buy their crude.

Bubble...

[Beris]

That's a good point alpha24/7. I couldn't agree more that there is abundant supply at these prices. Market will soon find its equilibrium. Thank you for your comments.

[maximax]

Not so sure what difference that miniscule increase in the gasoline retail price really makes. In Beijing a litre of gasoline is RMB5.34. Small Chinese refiners would still make a loss so they probably won't resume production. The large state owned ones have to produce anyway but they will still prefer to export their output to the world markets instead of selling at huge losses in the domestic market while begging the government to send in a massive check to restore their balance sheets. The government would have to prevent Sinopec et al to export refined products and set refining targets, but Sinopec et al are increasingly independent. At the same time the government is heavily concerned about inflation as China has a history of civil unrest sparked by inflation, and the Olympics are near... Myanmar's unrests were triggered by fuel price hikes, so hell would freeze over and Bush would go green before the Chinese government ever allowed refined products retail prices that could yield profits to domestic refiners. Was the latest price increase really to curb consumption? The government's main priority is economic growth (unsurprisingly, since much of the non-state owned economy is owned by commies and their families). It was a timid attempt to alleviate fuel shortages caused by the refinery game outlined above. Looking at other commodities driven into price bonanzas by Chinese growth (eg iron ore) it seems that they will push hard to lower the price through negotiations and alliances with key suppliers, but I am not aware of serious efforts to curb consumption. Ok there are these cuts in export rebates, but they have not changed much. Also, these unrests at Chinese petrol stations seen recently are not entirely uncommon as with or without shortages there are always long queues at petrol stations at the last day before the a price increase.

[Beris]

Yes, good points, but isn't this the whole idea by Chinese govt: to reduce subsidies? As you pointed above, their refiners are subsidized to straighten their balance sheets as they sell at the loss. But I believe that government idea is to stop that practice... but then again, as you pointed out, it's hard to believe that the intention is sincere, coming from the government "raised" on potential corruptive practices and/or family ties for years.

[Beris]

So far, so good. both oil and gold have been steadily sliding since I pointed out that the mini bubble might soon be bursting (gold at that time was $840, and oil $98). Trend is still down, and I don't expect it to bounce for a longer-term rally until they reach key support elements. Just an opinion.

[JJTERRITO]

Oil supply is so political beyond belief.There is as much or more oil left behind than that which has been produced.The single biggest contributor to our balance of payments deficit is imported crude.Our untapped resources have never been provided.If we are not interested in developing our own sources,why should foreign producers have pity on our misguided and stupid ways.

[Beris]

Well, I guess we are keeping our untapped resources for rainy days :) We'll show them all. Once the whole world is out of oil, we'll have it :)

Absolutely is political. Oil has been manipulated for years, and as long as it serves certain political interests we are doomed. Therefore, I am a strong supporter of any other alternative we can get, but I guess we are long ways from coming up with anything meaningful. We need a miracle to replace the oil, I guess. (not because of oil being used as a fuel, because we can come up with that), but because it will be hard to find a replacement for petroleum that is used in producing everything we know. But I guess any bit helps.