Is Oil a Bubble?

With Brent bumping up against the $125 mark and petrol/gasoline prices at record highs, many commentators are once again assuming that high prices are the new normal. Maybe. But perhaps not. Here are seven reasons why oil could see a sharp fall.

  1. High prices are being driven by fears of war with Iran. But we’ve been there before. Back in 2009, many were hyping a military strike and nothing happened. If markets get bored of waiting and begin to discount fears of an imminent attack, oil’s risk premium could shrink fast.
  2. Higher prices are bringing more oil onto the market. Iraq is now producing more than at any time since 1979 and hopes to quadruple production by 2017. Saudi Arabia has doubled the number of rigs it has deployed.  Offshore exploration is picking up as memories of the Deepwater disaster fade. Remember too that we’re yet to see the full supply response to the 2008 spike.
  3. At the same time, demand is being choked off by high energy prices. Oil helps explain why the US recovery is so anaemic. Meanwhile, both China and India have revised their growth projections downwards. HSBC has dubbed oil ‘the new Greece’ – catchy, an exaggeration, but at least somewhat true.
  4. Oil prices are putting import-dependent emerging and developing economies under growing fiscal pressure. In India last week, I was taken aback at how vulnerable high energy prices have made the country’s government. Energy and food subsidies have driven the deficit to an expected 5.6% of GDP this year. Many countries will have to cut expenditure or subsidies, or raise taxation somewhere along the line (and face the political consequences of these actions).
  5. The United States is importing less oil than at any time since 1999 – in part due to lower demand (changes in consumer behaviour due to the 2008 price spike are still filtering through the system) and in part due to resurgent domestic supply (tight oil etc.). Together with its growing shale production, this represents a significant shift in the pattern of demand.
  6. Speculative pressures appear to be pro-cyclical and could unwind rapidly. Oil consumers  are hedging (or trying to) against an Iranian supply shock, while pension and index funds are betting that oil will go higher. A change in sentiment could lead to a sudden bout fall in the price, as trade in paper-based oil exacerbates, rather than controls, market risk.
  7. It’s happened before. Brent was above $145 in July 2008. It then fell to $54 in just six months. Admittedly, the bottom had fallen out of the world economy and we seem to have stepped away from imminent catastrophe in the Eurozone, but the historical precedent should still dent the confidence of those who assume that, for oil, the only way is up.

So will oil fall? Much depends on what happens with Iran, of course. Other supply shocks could play a role, which is why reports of an attack on a Saudi pipeline  caused palpitations last week, and why MEND’s seeming resurgence in Nigeria is causing concern.

Oil exporters, meanwhile, are desperate to keep prices high(ish). Their fiscal breakeven points are now worryingly high, as governments use oil revenues to buy off restive populations. Saudi Arabia needs oil above $80 and Iraq above $100 before they start eating into surpluses or running up debt. In Russia, Putin’s tears of triumph may flow for less happy reasons: the Finance Ministry says it now needs S117 oil. Don’t expect to see them rushing to flood the market with supply.

And oil is clearly riskier and more expensive to produce than it was in the long, long bear market that followed the East Asian financial crisis. In the medium term, a new floor is probably being set for the oil price, determined by the cost of production for tight and deep sea oil, and for tar sands, and for opening up resources in some of the world’s least stable states. That floor, though, could be somewhat, or even considerably lower, than the current price.

My sense is that we can expect to see an extension of the current period of volatility. The scenario where prices jump again is realistic, but so is one where we see a lurch downwards. The market seems pretty frothy to me, and too many analysts have jumped uncritically on the high price bandwagon.

Policymakers need to continue to plan for unusually high levels of uncertainty. And they should be sure to ignore the false prophecies of those who claim to know what the oil price is going to do.