Some see oil bubble while others see trouble

John W. Schoen Senior Producer • Profile • E-mail

The recent trajectory of oil prices — a fairly steady increase followed by a much more vertical rise — has a familiar look to it. Remember those charts of tech stocks and housing prices? It's hard not to wonder: Are oil prices forming the next big “bubble?"

Those who see a bubble forming say you need look no further than the recent run-up in the cost of a barrel of crude to the current level of about $124.

“We were only trading at $86 about three months ago and not a whole lot has changed to move us to where we are now,” said Addison Armstrong, Director of Market Research for Tradition Energy. “There's no doubt in my mind — and most other people I speak to — we are in a bubble. And it's going to deflate at some point.”  

Many making the "oil bubble" argument cite the shape of a chart to make their case. For one thing, there’s no shortage of oil; inventories rose a bit this week and remain at just about the middle of the five-year average range for this time of year. Now that the Federal Reserve has signaled it may soon end its yearlong rate-cutting spree, the dollar — whose fall had been a big factor in the run-up of crude prices — is showing signs of strength. And a sluggish U.S. economy and high gasoline prices have begun to make a dent in demand.

Overheated speculation, the most common cause of any investment bubble, has taken hold in oil trading pits, according to bubble theorists. Fearful that a cutoff in supplies could send prices skyrocketing, oil traders and their customers (hedge funds and industrial oil consumers) are willing to pay high prices to lock in supply at a predictable price. As long as those traders and industrial users think supplies are at risk, that “premium” is likely to remain.

The fears of a supply cutoff aren't without merit. There is so little excess production capacity today that the loss of a major supplier could create a shortage of oil. That has led to worries that oil prices could jump even further. Last week, a Goldman Sachs analyst created a stir by advising clients that oil prices could reach $150 to $200 a barrel over the next six months to two years, though he said the outlook “remains a major uncertainty.”  (His official forecast: oil will sell for $108 at the end of this year and gradually rise to $120 in 2010.)

Many analysts see prices moving the other way. According to the consensus forecast tracked by Thomson Reuters, oil prices are expected to end this year around $91 a barrel, falling to $90 by the end of next year and $82 by the end of 2010.

Bubble proponents argue that if demand for oil continues to ease and supplies hold up, the speculative fever driving up prices could quickly evaporate, and prices could fall sharply.

It wouldn’t be the first time prices have crashed. In 1986, oil prices began the year at $26 a barrel. By March, crude was selling for $10.25. In 1997, prices peaked in October at nearly $23 a barrel only to fall below $11 a little more than a year later.

But the forces that caused those oil “crashes” aren’t evident today. The 1986 slide was the result of heavy overproduction by OPEC, when Saudi Arabia opened the spigots after fellow cartel members cheated on their quotas. The 1998 pullback also resulted from a huge oversupply after the Asian economy unexpectedly slowed sharply as a currency crisis swept through the region.

Today, the world’s oil producers have little extra capacity, and the Asian economy is booming. Bubble skeptics say that while oil prices may be due for a pullback, the longer-term trend is clearly higher.

“When I hear bubble, I'm thinking of a technology bubble where we spike up and we just never come back to it again,” said Chris Jarvis, an energy analyst at Caprock Risk Management. “I don't think that’s the case. I think if anything you’re talking about more of a short-term pullback. What is short term? I don't know, nine months to a year. But the trend higher is still  intact. I would definitely not call it bubble.”

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