Flying Pink Unicorns

Oil prices. Where do they go from here.

First, oil prices have gone NUTS. As any of you who own a car are painfully aware, oil prices have gone through the roof. As I write this on 4/16/08, oil is at $113 a barrel. This is staggering! It is also a classic BUBBLE. This bubble, like the recently burst housing bubble, the tech stocks bubble, the baseball card bubble of the 1980s (yes, there was one, a BIG one for that tiny market) and all other bubbles down through history occur when, for various reasons, prices get completely out of whack with a "normal" supply and demand curve. For example, the demand for tech stocks with few revenues, no profits (laugh) and no clear way to BECOME profitable grossly exceeded the supply for several years. Accordingly the prices shot through the roof. Now of course the main reason why demand consistently exceeded supply was the greater fool theory. That is, you could always unload the thing on some other sucker. Until the game of financial musical chairs ended, that is.

Look up the tulip bubble, at http://en.wikipedia.org/wiki/Tulip_mania for an absolutely fascinating story of how prices can get out of line. What a mind boggling bubble that was!

Anyway, oil prices are now in a bubble, a BIG one. Well, partially a bubble. Demand has soared in recent years, and that's no bubble. China, you may have heard, is fast growing. REALLY REALLY fast. India too. The US has grown. In fact, the world economy grew more in the last few years than at any time since the 1950s. It was quite the boom while it lasted. So part of the oil price run up is "real," by which I mean demand really has sustainably increased. But part of it is a fear in the oil markets regarding Iraq, possible war with Iran, instability in Venezuela, and so on. And a bigger part of it, imho, is that there is a LOT of money sloshing around the world financial system that needs a home. Interest rates have been low and are now dropping some in the US, so bonds aren't too attractive. Why not buy commodities (or more accurately bet on oil prices increasing)? People have. In HUGE amounts. Some of this is well outside of my knowledge, but the people I read have long felt that a fair bit of the run up in oil prices the last few years is simply speculative froth that will wear off.

Another part of the oil run up is the precipitous fall of the US dollar. For historical reasons, nearly all oil contracts are priced in DOLLARS. Well, you're Saudi Arabia. The dollars you get don't buy nearly as many Euros/Yen as they used to. Figure it out.

Why will oil prices very likely decline from here:

A) Demand growth will slow considerably. The US is in recession, which slows demand growth. The Euro economy is slowing, and the UK is probably headed for a housing led recession. This will slow growth. China is trying to slow its economy. This will slow growth.

B) The dollar will not keep falling for the next few years. I think. (Heaven help us all if it does).

C) The Bubble will burst. Demand on the spot market will drop as betting on oil prices is no longer a one-way winning bet.

On the political instability front, I don't know what will happen. It wouldn't surprise me a bit if the situation in the world oil producers became more stable. A perfect storm is possible, where oil prices quickly crater (to a still high number, say $70 a barrel).

Which brings me to my last point. Andrew and I have made one of our periodic wagers. Now my record in these wagers is NOT good. I am approximately 1-7. That is, I've won 1 (I think) and lost around 7. With that in mind:

I have wagered that sometime between now and the end of the decade, 12/31/09, Oil will drop below $80 a barrel. Andrew has wagered that it will not. A fancy dinner, plus the more important bragging rights, are at stake. It has a relatively long way to drop and a somewhat short time to do it, but I'm convinced this is a bubble, and bubbles DO burst. The only question is when. Wish me luck. Against the Goliath that is Andrew, I'll need it.