How Big is the ‘Oil Bubble’?

"If you go into what I call a bubble boom, every bubble bursts."
                                                                      - Margaret Thatcher

By Haresh Soneji, CNBC-TV18

Bubbles are rarely avoidable, especially when they are based on stretched fundamentals. Clearly fundamentals seem to have run ahead as far as oil is concerned. At least, that's what legendary investors such as George Soros believe. Every time I wonder on fundamentals, I get bogged down by the thought, 'it's the sentiment, stupid'. And so many textbooks table that short term movements are all about sentiments, where fundamentals have no role to play. The world Energy watchdog's - International Energy Agency (IEA) statement seems to be vague. While it says that growth in global oil demand is headed for a six year low, it cautions on supply stating OPEC pumping capacity is lower than witnessed in 2006 and that oil supply in non-OPEC countries continue to remain uncertain. Focusing on the oil analyst that predicted oil at $200 a barrel, this Goldman Sachs analyst now says that the level is unsustainable and crude would slip to $75 a barrel in the long term. The other theory states that many commodity prices have multiplied in the previous few years, but crude was the only one that did not rise to that extent and now its just playing catch up. In all, its all very confusing, at this point in time.

So, let's focus on something that everybody agrees on - fundamentals. All experts point that crude prices seem to have rushed ahead of fundamentals. So, the trillion dollar questions are will and when the bubble is likely to burst? The truth is no one knows the answer. But to me, when the bubble will burst is the likely question to be asked. The 'will' bit seems more likely to be factored in.

Having said that, let's focus on how big the 'oil bubble' could be? The Economist states that oil trade has risen some 20 times since 2002 and estimated to be some $5 tn. Another interesting way to look at it is perhaps the volumes in NYMEX. Light sweet crude volume in NYMEX has jumped some 40% since the previous year or so. A quick math on the numbers, at current market prices, suggests that speculation multiple is 10x the current actual consumption of crude.

Jun 2008

• Avg daily No. of contracts traded - 0.8mn
• Crude price - $130 approx
• Daily trading @NYMEX - $104bn
• Daily world consumption - $10.4bn
• Speculation multiple - 10x
• US accounts for 25% of world output

Now only about a year back, the speculation multiple was 6x.

Jun 2007

• Avg daily No. of contracts traded - 0.4mn
• Crude price - $70
• Daily trading @NYMEX - $35bn
• Daily world consumption - $6bn
• Speculation multiple - 4.7x

Speculative activity no wonder has risen sharply in NYMEX. But, is this the right way at looking at things? Probably not. It however is a rough barometer on the speculation. If daily speculation is 10x world consumption, speculation is really high. A quick comparison with equities shows that futures to cash at 5x shows sell sign as markets are highly leveraged. Multiples in oil futures are up 10x to daily consumption.

There are also several economic factors at large that are inflating prices - supply issues, shortage worries, increased consumption, increased reserves by US, new and alternate resources are some of the reasons. These are long term issues, but speculation is probably the single biggest factor and very immediate.

So, if the bubble bursts and oil prices trickle down, would it be positive for equities? Not really. A bubble break has huge implications to other asset classes. Remember the dotcom bubble bust. Losses on leveraged positions get trickled to other assets leading to selling and sentiment scare across the board. Prices cooling slowly is what investors the world over should pray for. A hard landing is not what the equity market wants - definitely not at this point in time.

Disclosure: The author is not permitted to trade and/or invest into the equity market directly or indirectly, apart from investing (long only) in mutual fund products. His equity exposure is only to the extent of ESOPs granted by the employer.