Oil price bubble will burst with a bang like dot-com did

The steep run-up in crude prices this year has been compared with the dot-com period of the previous decade with an equally severe fall in the per-barrel cost of oil forecast. "It is difficult to project when market perceptions will turn from the current bullish sentiment. It will almost certainly take a persistent stock build. It might also take a rise in the dollar against the euro and the psychological impact that could have over time," investment bank Lehman Brothers said in an oil market report released yesterday. "In the meantime, market momentum is likely to continue to reinforce the view that even if peak oil is not yet here and even quite far off, there is unlikely to be new supply in the market for at least half a decade. Summer market tightness could, under these circumstances, continue to propel oil prices upward to untested levels. "But when peak prices hit, we believe they are also likely to fall precipitously. That's the way cyclical turning points tend to occur – in the midst of a market trend, turning points can be sudden, unexpected, and severe. If history is a guide, the turning point will come. Getting the timing right is the difficult part," Lehman's researchers said. The bank has cited several factors that it believes drove oil prices sky-high, not the least among them being massive cash flows from pension funds, sovereign wealth funds and other large investors into the commodities market. This, it said, has put in place the "classic ingredients" of an asset bubble. "We have argued recently that some of the price buoyancy during the first quarter reflected financial flows and investments in oil and other commodities… We argued that large investor purchases of commodity indices and other structured products had a measurable effect on prices during the period leading up to the beginning of second quarter. "The motivation of investors – mostly institutional investors from pension, endowment, and sovereign wealth funds – was to take advantage of commodity fundamentals with the expectation that commodities would outperform equities and bonds in the period ahead," Lehman said, referring to its Energy Special Report published on May 16. The earlier research had discovered that from January 2006 to mid-April, more than $90 billion (Dh330.3bn) of incremental investor flows were devoted to total assets under management (AUM) by commodity indices, as opposed to the price appreciation of the underlying assets. Lehman had said at the time that for every $100 million in new inflows, WTI prices increase by 1.6 per cent. "Our conclusion from this study is that we are seeing the classic ingredients of an asset bubble. Financial investors tend to "herd" and chase past performance, comforted by the growing analytical conclusion that markets are tightening, and new inflows, in turn, drive prices higher. Larger allocations by institutional investors, including new sovereign wealth funds, desiring to increase their commodity exposure, play a role. "So does uncertainty about the true state of market fundamentals, including the level of Saudi spare capacity, the level of Chinese "real demand" versus stockpiling, and other factors that buttress the current bullish consensus," the investment bank said yesterday. Supply side Non-Opec production has continued to go down. Mexican output in April fell by 13 per cent year-on-year in tandem with a persistent fall in Russian and North Sea flows, and the market continues to discount Saudi production increments and the rise in Saudi surplus capacity. "In an environment in which demand is bumping against capacity constraints, commercial inventories fail to grow, and surplus production capacities are significantly eroded, prices need to grow exponentially to balance the market," Lehman report said. The market perceives that this condition, which was prevalent in 2002-2007, still dominates the market, and it provides the basis on which many analysts have increased their price forecasts for this year. "Another factor that has become part of the current analytical consensus is that forward prices have not yet reached a level high enough to trigger new supplies. There is little doubt that some of the increased investor flows into the long dated market stem from this belief, just as a significant share of the flows arise from political uncertainty about a potential flare-up with Iran," the report said. A regional military conflict accompanied by a disruption in oil shipments through the Strait of Hormuz would certainly result in a price increase, it said. "It is our judgment that forward prices have already reached the point at which new supplies can be triggered, and we believe that it is a double – rather than triple-digit level. "Relative interest has been shifting to further out-of-the-money calls, reflecting a growing bullish attitude by short-term investors. This attitude change was particularly acute during April, growing with a crescendo along with market sentiment th