Construction Finance Threatened by the Inevitable Popping of the Oil Bubble

06/11/2008 by Jim Haughey

Share

Why has the price of crude oil in the US risen from $95 to $135/bbl. so far this year when world oil supply has increased 1.5 million barrels per day and world oil consumption has declined 1.1 million barrels per day over the same period, according to the latest data from the US Department of Energy? Only a small share of the rise can be due to the depreciating dollar which has declined about 3% since the end of last year.

 

This dilemma should be familiar.  A decade ago we wondered how the capital value of Internet and telecom companies could exceed that of General Motors, General Electric, Citibank or Exxon when the new technology companies often had few products and no profits. A few years ago we wondered how home prices in the Southwest and Florida could rise at a 40% annual pace for a sustained period when construction costs were steady and there were lots of empty homes.

The internet bubble and the housing bubble are now being followed by the crude oil price bubble. Again, the market price can vary from the equilibrium, market clearing, price for more than a year if buyers believe that prices will continue to rise and that other buyers will appear to pay them even more on the belief that prices will continue to rise more.

The mechanics of the housing price bubble are now known to be the alternative mortgage market with initially low teaser interest rates and skip payment options that permitted financially unqualified buyers to delay their inevitable foreclosure for more than a year. The mechanics of the current crude oil price bubble is the combination of the oil futures market and acquisition of oil storage facilities by speculators. The futures market permits the price of physical crude oil to be controlled by speculative demand and supply for many months until the futures contracts expire. Oil storage facilities permit people without refineries to control the price to refiners even longer. And still strengthening fundaments, mostly political interruptions of oil supply, permit speculative owners of oil to convince more people to invest in oil, keeping prices rising through another cycle of futures contracts.

•

Crude oil prices jumped above the level that would clear the market in September 2007, considering only sellers who actually produced crude oil and buyers who actually had refineries. So crude oil prices have been rising large on the faith in the inevitability of higher prices for about nine months. Compare this to what happened to home prices. Home prices rose at an annual rate of 15% or more – beyond the impact of market fundamentals alone – for about seven quarters during the 2004-06 housing boom. The period of price rise largely on hysteria ranged from four quarters in San Diego to eleven quarters in Los Angeles. The bubble lasted for six quarters in Las Vegas and seven in Phoenix and in Sarasota-Bradenton. Weaker and shorted bubbles occurred in northern California, New England, Seattle and Washington.

This suggests we should be expecting the crude oil price bubble to pop sometime from this summer through next winter.

Recent Comments

Where does the increase in the cost of exploring for and extracting oil fit in with this equation?
Juvarya Warsi -
Jun 13 6:03 PM
The cost to bring to market the last barrel of oil needed to meet demand at each price defines the supply curve for crude oil. This cost has soared from less than $5.00/bbl. 35 years ago to somewhere in the $30's a few years ago to somewhere in the $40-60 range currently. The rapid increase is due both to a shift in the demand curve as oil demand increased in the developing world and a shift in the supply curve as ever higher volumes of oil required producing oil from deeper wells, wells in hostile environments and adding pressure to force the oil to the surface. Together, the higher demand and higher production costs provided the underlying rationale for the oil bubble to develop. After the bubble pops and the panic clears, the price of oil will settle at a level $10-$20 higher than would have been expected a few years ago.
Jim Haughey -
Jun 19 9:26 AM
I understand the underlying link between the cost of oil and the difficulties with its extraction. My question is how will a bubble pop - especially if the supply-side factors remain constant? Do you predict a drop in demand?
Juvarya Warsi -
Jun 19 7:18 PM
The pop will not be from a drop in demand although there has been already and will continue to be falling demand from very high prices. The demand drop will accelerate as other countries remove subsidies and boost the price of fuel sharply higher. The pop, as always, will come from the realization that have risen far above the market clearing level so that speculative buyers rush to get out of the market and drag prices down quickly with their panic sales. this is exactly what happened to Florida, Nevada and California home prices last year.
Jim Haughey -
Jun 23 8:51 AM