Unexpectedly Intriguing!
August 15, 2005

Do you remember the lyrics for the Beverly Hillbillies? Just in case I haven't just stuck the theme music in your head for the rest of the day, here is the first verse of "The Ballad of Jed Clampett":

Come and listen to a story about a man named Jed
A poor mountaineer, barely kept his family fed,
Then one day he was shootin at some food,
And up through the ground came a bubblin crude.

Oil that is, black gold, Texas tea.

Source: Lyricsbox

The reason why I've firmly lodged the Beverly Hillbillies' theme music in your head is because the ever watchful eyes of bubble-obsessed economic analysts have detected a bubble in crude oil prices. With the housing sector of the economy appearing to be cooling off at last, the increase in crude oil prices provide the hand-wringing set with ample opportunity to, well, wring their hands while complaining that the housing bubble was hiding the oil bubble all along. Then again, if they weren't complaining, would we even notice they exist?

On the other hand, the rapid surge in oil prices over the $65 USD per barrel level may indicate better things to come. David Smith of EconomicsUK offers his thoughts (emphasis mine):

While the futures market suggests that oil prices will head gently lower, many market participants are not so sure. Options markets suggest that the chances of a big rise in prices are greater than those of a big fall, with a 1-in-20 chance of prices being $100 a barrel or more in a year.

I’m not so sure. This is a nervy time for the global oil market, but the surge in prices has all the characteristics of a classic bubble. The International Energy Agency, in its latest oil-market report last week, said: "The unfolding statistical picture increasingly reveals that fear of the unknown and the consequent desire to make forward oil purchases is behind oil’s higher price path."

It also warned that while the emphasis now was on the risks of higher prices, "as stocks and spare capacity increase, it must not be forgotten that the downside price risks will eventually emerge as well". It predicts a rise in oil demand of 1.75m barrels a day in 2006, but a bigger increase in supply, split between Opec and non-Opec countries. Opec’s margin of spare capacity, currently a wafer-thin 1m barrels a day, will rise to 3m.

That does not mean oil prices are going to collapse. It does mean they are likely to return gradually to earth — which probably means a sustainable $40 a barrel — when geopolitical worries subside.

Barry Ritholtz of The Big Picture agrees that oil prices will come down substantially, but will do so as part of reduced demand stemming from the next trough in the business cycle:

My B-in-L Bob, a very senior BP exec (now retired), is the one who initiates the "Oil is a bubble" discussion. All the inflation adjusted charts seem to only go back to include the 1970s --- and that's not far enough to show the true price trend of oil. Bob argues that Oil has been in a very long downtrend, and the 1970s price spike was an aberration. So too, the 2003-05 run up. A longer, inflation adjusted chart would reveal that the present spike is aberrational, and unlikely to be sustainable. I am somewhat incredulous of this claim.

His point however, is well taken. While he is expecting an eventual mean reversion, simply base dupon price, I have a similar expectation based upon market cycles. The next recession (there's always a next recession, just as there's always a next recovery) will see reduced demand for Oil, and that will allow prices to fall.

Finally, to make up for starting this post by quoting lyrics from the Beverly Hillbillies' theme song, here's some Shakespeare to make up for it:

"Double, double toil and trouble;
Fire burn, and cauldron bubble."

- William Shakespeare, Macbeth

Undoubtedly, the Bard was concerned with skyrocketing oil prices....


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