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 that was becoming bullish.

"Starting around May 15, investor interest in $120 strike prices peaked and began to unwind; meanwhile, interest in higher call, particularly at $150 strikes, continued to rise. One indication of that interest is that as the year has progressed, prices of $150 December 2008 calls rose from less than $0.30 to nearly $8.

"What has been striking about the rise in the back end of the curve over the first three weeks of May has been… nearly a complete lack of interest by producers in selling oil forward.

"In the past, producer selling would have slowed or impeded the upward price drive. In its absence, retail investors, hearing a growing number of reports about "peak oil", continued to buy at higher and higher strike prices, indicating that there is no necessary physical ceiling to the market.

"Meanwhile, a number of banks and well-known investors publicised their views that the long run was also going to be tight for oil markets. For some of these analysts/investors, the reason for higher prices had to do with the need to trigger an adequate supply and demand response; for others, it was because they believed peak oil had arrived and, in their opinion, Saudi Arabia could no longer raise its crude oil output."



Other investor triggers

As the back end of the market rose, several other investor triggers reinforced the move upward.

These included a rash of new consumer hedges by airlines, locking in prices through 2009, boosting the first 12 months of the forward curve. In addition, numerous investors had "bullish" structures in place, expecting backwardation to strengthen as markets tightened. They were long the front and short the back of the curve, and as the producers have not been active, back end of the curve moved from backwardation to contango, they had to stop out their positions and unwind them in a non-liquid market.

The triggering event appears to be some combination of an end to the stopping out of positions and, more forcefully, the re-entry of producers to the market to hedge, according to Lehman.

"Doing so, they take advantage of record high deferred prices and arbitrage the difference between current forward prices and their costs structures, which have not inflated at the rate at which deferred prices have risen," the report said.

"Several other features of the moves of the past three weeks also stand out. What happened to the oil market – at the front end of the market, but even more so at the back end – was special to petroleum. Unlike other sudden increases in oil prices since last September, the recent move was not reflected in a broad grouping of other commodities.

"To the contrary, it was not even reflected in natural gas, which arguably should have been more closely tied to oil. On an energy-equivalent basis, five-year deferred natural gas on May 20 was worth only 46 per cent of oil, whereas on May 1 it was 54 per cent.

Stealth supply lurks under the bubble

Incremental supply increasingly depends on Opec's willingness and ability to develop and produce oil, Lehman said. "In our 2007 year-end analysis of oil markets, we noted that the declining share of incremental oil from non-Opec countries in 2008-2010 would test markets. At the same time, we concluded that over the next three years, under almost any demand scenario, incremental Opec capacity should be sufficient to more than balance markets.

"Through 2009, our analysis indicates that global production capacity should be growing at twice the rate of global demand, and through 2010, any incremental surplus capacities developed through 2009 should carry over.

"A short-term imbalance between potential supply, including shut-in capacity, and demand should not emerge again until 2011 or beyond.

"Three perceptions increase the market's doubts about supply. First, Saudi Aramco officials have re-confirmed that the country will have sustainable capacity to produce 12 million b/d by 2009, excluding the Neutral Zone, which adds another 300-400kb/d to that base. "Second, markets doubt the ability of other Opec countries to add capacity with continuing violence in Iraq and Nigeria.

"Third, doubts about non-Opec supply cloud the supply picture."

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