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Oil Bubble?

Even faster than Gold, the oil price has shot to undreamt of heights. Why...?

crude oil's parabolic rise – doubling from a year ago, to above $130 a barrel in May – central bankers who under-estimated the power and resiliency of the "crude oil vigilantes" are now praying for this apparent bubble to burst under its own weight, and at a moment's notice, writes Gary Dorsch of

   In an interview with The Daily Telegraph in London, one of the world's biggest hedge fund traders, George Soros, said that although the weak US Dollar, depleting supplies from aging oil fields, government fuel subsidies, and record Chinese and Indian demand could explain the surge in energy prices, the crude oil market is also significantly inflated by speculation.

"Speculation is increasingly affecting the price, which has a parabolic shape, which is characteristic of bubbles," said Soros.

However, he also warned that the oil bubble won't burst until both the US and British economies slipped into recession, after which event, oil prices could fall dramatically.

"You can also anticipate that the [oil] bubble will eventually correct, but that is unlikely to happen before the recession actually reduces the demand. The rise in the price of oil and food is going to weigh and aggravate the recession."

It's dangerous to pick a top in a raging bull market, since bubbles can inflate more than anybody ever imagined. On May 20th, T.Boone Pickens – the legendary oil trader and investor – told CNBC he expected crude oil prices to keeping going up, even from here.

"I think we'll get to $150 this year," he reckoned. The next day, soon-to-be deposed Israeli prime minister Ehud Olmert called for a US naval blockade of Iran. If that happens, crude oil could shoot to $200 per barrel.

Who is Inflating the Oil Bubble?

Chief culprit is the Federal Reserve, the US central bank. By slashing 325-basis points off the Fed funds rate – taking it to a negative 2% after adjusting for inflation and expanding the US broad money supply by 16.5% from a year ago in a desperate effort to stop the slide in the sinking US banking sector – the Fed encourages speculation in commodities by pushing down the Dollar.

That, in turn, pushes up the price of Dollar-denominated commodities such as crude oil, soy beans and Gold.

So far, the Fed's aggressive rate cuts haven't found any meaningful traction in the S&P Banking Index, which is still languishing at its March lows, some 40% lower from a year ago.

Banks continue to post hundreds of billions in losses from toxic sub-prime mortgage debt. But the Fed's single focus on rescuing the banking sector, with no regard for the inflationary consequences of its actions, has led to the emergence of the "crude oil vigilantes".

   Much like the famed "bond market vigilantes" of the late '70s and early '80s – who sold US Treasuries hard, pushing up bond yields and forcing the Fed to raise its interest rates – these traders are now punishing central bankers who have too abusive with the world's money supply. The crude oil vigilantes merely swap bonds for oil prices.

   In the past, a sharp slowdown in the US economy, the world's biggest oil guzzler, usually pushed the price of crude oil and other commodities lower. But the Fed was caught by complete surprise after crude oil prices doubled, even as America's economy slipped into a recession in the first quarter.

   "The current oil price has no relation to market fundamentals," explained Saudi oil chief Ali al-Naimi on March 5th. "It is linked to tremendous speculation in crude oil futures. There are even those who buy futures and speculate that oil prices will reach $200 in 2013."

   On April 28th, Opec chief Chakib Khelil observed that crude oil prices were climbing "even though supply is adequate, because the market is driven by the dollar's slide. Each time the Dollar falls 1%, the price of the barrel rises by $4, and of course vice versa.

   "If for instance, the US Dollar would strengthen by 10%, it is probable that oil prices will fall by 40%."

   But such simple logic has its limitations. China, India, Russia and the Middle East combined are now consuming more crude oil than the United States, burning 20.7 million barrels a day – some 4% from than a year ago, according to the IEA.

   The emerging economies are picking-up the slack in the oil market, more than offsetting the 1.3% contraction in US oil demand forecast this year to 20.3 million barrels per day. Thus a mild recession in the Western economies and Japan might not weaken global demand for oil.

Oil Bubble: A Hedge for Much More Than the US Dollar

   What's more, big oil exporters like Russia, Mexico and Opec itself are growing so fast economically that their need for energy within their own borders will limit how much they can sell abroad.

   Internal oil demand in Saudi Arabia, Russia, Norway, Iran and the United Arab Emirates grew 6% last year, and their exports declined 3%. Mexico's oil output fell 9% in the first four months of 2008. If these trends continue, global crude exports could fall by 2.5 million barrels a day by the end of 2010, adding new strains to the global oil market.

   Yet it was shocking to hear Minneapolis Fed chief Gary Stern on May 28th, refuting the linkage between the US Dollar's sharp decline and soaring energy prices, and denying any responsibility for the global Oil Bubble – also known as the "Oil Shock".

   "I'd be careful about mistaking correlation and causation. Just because energy prices and the Dollar seem to move together, that doesn't mean that there's causation there. If you're thinking about energy prices, bear in mind that there's been some very significant changes in the global economy that have something to do with this.

   "I would point to the very rapid growth in China and India in recent years, and places like that."

   Crude oil speculators on the Nymex were buying "black gold" as a hedge against the US Dollar's slide against the Euro, the world's No.2 reserve currency. And perhaps traders in London – also picking up the mantle of "crude oil vigilantes" – have been buying North Sea Brent as a hedge against the British Pound's devaluation, too.

   The Bank of England engineered the British Pound's sharp devaluation against the Euro by joining the Fed's rate cutting spree last November. Over the last 8 months, it's made three quarter-point rate cuts to 5.0%.

  The European single currency – still paying less to cash savers, but with the European Central Bank (ECB) and its "anti inflation" rhetoric behind it – soared 17% to break above 80 pence per Euro. At the same time, North Sea Brent crude oil prices doubled to $130 per barrel.

   Flipped the other way round, the British Pound buys around €1.25, down from €1.50 last summer, making European imports considerably more expensive. For Ivory Tower economists, the Euro's ascent against the British Pound and US Dollar – both of which closely tracked crude oil prices – was just a statistical coincidence.

   But for crude oil speculators, the sharp devaluations of the Pound and US Dollar translated into enormous windfall profits in their brokerage accounts.

   Whatever the truth of the Oil Bubble's beginning – and the part played by crude oil vigilantes in the London and New York markets – it's always good to have the basic fundamentals on your side when riding the waves of a strong bull market.

   Oil production is shrinking in 54 of the world's top 60 oil producing nations, including Britain's North Sea fields – where output peaked in 1999, and has already plunged by half.

   The UK began importing liquid gas for the first time in history in July 2005, and its North Sea oil reserve is dwindling at an 8.5% annual rate. Indeed, the curtain might fall on North Sea Brent by 2012 if enough isn't done to maintain development and exploration, according to the UK Offshore Oil Industry.

   But political pressure on the Bank of England for more rate cuts could intensify after British housing prices dropped for the eighth straight month in May, down 2% from a year ago. The average selling time for UK homes has climbed to almost 10 weeks, compared to 5.8 weeks in May 2007. And a further slide in home prices could topple the UK's asset-based economy into recession, deepening losses for British banks.

   Another round of BoE rate cuts could renew selling pressure on Sterling and buoy Brent crude prices, oil bubble or not. But currency devaluations do not fully account for crude oil's dramatic rise to $135 per barrel last week. "Peak Oil" theorists have an equally strong explanation, and Saudi Arabia's threat to ramp-up oil production by 2012 is sounding hollow.

   Currency swings do magnify the volatility and price trends in the crude oil market, however, the same way the "Yen carry" trade magnifies swings in the global stock markets. The massive volatility in Gold Prices – a proxy for global faith in paper currencies – only adds to the pressure on central banks applied by crude oil vigilantes.

   No market travels in a straight line forever, and shakeouts in the crude oil market are designed to wipe-off the speculative froth. However, a British and US economic recession would not necessarily burst the oil bubble, especially not if the net result is another sharp devaluation of the British Pound and US Dollar in the foreign exchange market, which would support high oil prices.

Oil Bubble: Subsidies Foil Supply & Demand in China

   The basic laws of supply-and-demand don't work in an economy where the government intervenes with price controls. And in China, gasoline prices haven't gone up since last November, even though crude oil prices have gone up 35%.

   Beijing controls gasoline prices to limit their effect on inflation, and it prevents refiners from passing on higher oil import costs to consumers. Without the price controls on energy distillates, Chinese inflation would already be in the double digits, threatening social unrest.

   China Petroleum & Chemical (Sinopec) said its first-quarter net profit fell 69% from a year earlier due to surging crude oil costs. Sinopec imports about 80% of its total oil needs, and its refineries break even if oil import prices are $76 a barrel or lower.

   To cover its losses, SNP received a government subsidy 4.9 billion Yuan ($700m) in the fourth quarter and 7.4bn Yuan ($1.1bn) for the first quarter of this year.

   So at a time when global oil giants are reporting record profits, Chinese oil companies are suffering heavy losses because of government controls freezing retail gasoline and diesel prices.

   Refiners must still pay rising market prices for crude oil, of course, while the Beijing authorities force them to accept below market revenues. That's why PetroChina – China's biggest oil company, and the most heavily weighted stock in Shanghai – said its first quarter profit plunged 31.5%.

   Last week, a rumor was floated that Beijing would allow higher prices for gasoline and diesel supplies, and Sinopec quickly surged 10%, the daily stock market limit. PetroChina's stock jumped 7% to 17.86 Yuan.

   But these rallies fizzled out after Beijing squashed the speculation. Beijing controls $1.75 trillion in foreign exchange reserves, and can easily subsidize fuel at artificially low prices for many years to come – which means Chinese demand for oil can continue to increase by 500,000 barrels per year.

Oil Bubble: India's Buffer for the Global "Oil Shock"

   India is Asia's third-biggest oil consumer, and imports 70% of its petroleum needs. Although crude oil has doubled from a year ago, and the Indian Rupee has managed to lose 5.5% against the Dollar this year, New Delhi has only permitted just one increase in retail fuel prices in 20 months.

   India's widely-tracked wholesale price index was 7.82% higher in May from a year ago, the highest in three-and-a-half years. It would be in double-digit territory without the price controls on fuel.

   India's big-3 oil refiners – Indian Oil, Hindustan Petroleum, and Bharat Petroleum – have borne the brunt of the crude oil spiral. Now they are expected to report combined losses of 1.8 trillion Rupees for the past year ($421bn) from selling fuel below cost.

   Oil companies, which bear the brunt of the price-control mechanism, are compensated partially through subsidies from upstream companies and oil bonds from the government. Now India's petroleum ministry is pitching for a reduction in the taxes and duties that account for about 55% the retail price of petrol.

   But the government earned a whopping 71,000 billion Rupees in 2006-07 from taxes and duties on petroleum products. Thus, the Finance Ministry might object to a reduction in petrol taxes, which constitute such a big chunk of the government's revenues.

   Like the People's Bank of China, the Indian central bank prints local currency – in this case Rupees – to exchange for US Dollars bought on the foreign exchange market from export firms building up huge profits from US consumers.

   The Reserve Bank of India has built-up a sizable stash of foreign exchange reserves now totaling $315 billion. This massive build-up of FX reserves can help India to cope with major external shocks, such as the surge in oil prices. In the past sixteen months, India's imported 121 million tons of crude oil crude oil, up 9% from the same period a year earlier, and its oil import bill jumped 40% to $68 billion.

   The Bank of India also bought $17.5 billion since the start of 2008 to keep the Rupee from gaining against the Dollar, which is inflating the broad "M3" money supply at a 22% annualized rate. Combined with soaring food and energy prices, this threatens to ravage its economy with hyper-inflation and social unrest.

   India's central bank is relying on cash management tools rather than interest rates to fight inflation, lifting the bank's reserve ratio to 8.25% – its highest in seven years – to force commercial banks to drain a token amount of liquidity away from new lending.

How to Burst This Liquidity-Driven Oil Bubble

   What could possibly knock the mighty crude oil market off its upward course? Only a coordinated round of interest rate hikes by the world's top 20 central banks.

   Consider the Shanghai red-chip stock market, for instance – one of the four biggest bubbles in stock market history. It increased five-fold in less than two years to a record 6,120 last October, before it deflated by 50% over the next seven months.

   Shanghai lost half its value because the People's Bank of China (PBoC) pursued a carefully calibrated tightening campaign that drained trillions of Yuan out of the local money markets. The Chinese central bank "pricked the bubble" in the Shanghai stock market when it hiked bank reserve requirements by 1% on Dec 8th to 14.5%.

   One Yuan in every seven deposited with commercial banks was to be left in reserve. In turn, that screw on fresh lending knocked the red-chip index below the psychological 5,000 level.

   But the PBoC didn't stop its tightening campaign at 14.5%. Instead, it continued to hike the level of cash that Chinese banks must hold in reserve to as high as 16.5%, and thus dealt a punishing blow to over-zealous speculators in the market.

   Of course, the PBoC can afford to tighten its monetary policy. Because unlike Western nations, its banking system isn't infected with toxic US sub-prime mortgage debt.

   The PBoC tightened liquidity, with the permission of the central government party bosses – and even at the cost of knocking the Shanghai stock market lower – in order to contain inflation pressures.

   Yet despite the PBOc's tightening campaign, China's M2 money supply is still 18% higher from a year ago. Combined with soaring commodity prices, it's fueling an 8.5% consumer-price inflation rate, the highest in 12 years.

   Since crude oil is still denominated in the US Dollar – against which the PBoC continues to hold down the Yuan in a bid to retain export competitiveness – it's the Bernanke Fed, which has the "magic wand" that can deflate the bubble in the crude oil market. To do that, it must deploy the same tactic used by the PBoC:

   Tighten the Fed's monetary policy, in order to strengthen the US Dollar and end the great Oil Bubble speculation and crude oil vigilantes.

   But does anyone believe President Bush would give the Bernanke Fed the "green light" to lift interest rates ahead of an election, when US home prices are tumbling?

   On May 15th, the most radical inflationist appointed by Bush to the Federal Reserve, Frederic Mishkin, argued that actions such as attempting to prick a price bubble with interest rates should be avoided.

   "Just as doctors take the Hippocratic Oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good," said Mishkin, who just left the Fed to return to academia.

   "Interest rates are too blunt an instrument for targeting sharp rises in specific asset prices."

   Mishkin also argued that the Fed should downplay energy price increases, and that the Dollar's devaluation was not a problem. "Fluctuations in exchange rates are something that you have to deal with, but as you know sometimes the media make a huge deal of fluctuations that is way over the top," he said on March 7th.

   His speeches built the framework for the Fed policy that is currently being implemented, and has lead to the US economy deep into the "Stagflation" trap, and responsible for the Global "Oil Shock".

   But confirming the direction of Fed policy from here, "Rick's contributions to the intellectual underpinnings of monetary policy at the Federal Reserve have been invaluable," Fed chief Ben Bernanke said on May 28th after Mishkin resigned in order to teach his wacky theories at Columbia University.

   On the other side of the Atlantic, meantime the soaring food and energy costs are squeezing hard-pressed British consumers more than ever. The government's inflation rate jumped to 3% in April, driven by higher food up 7% and fuel up 9%.

   But the average British house is expected to sink by 14% – some £26,000 – in the next 12 months, after falling 5% since the market peaked in August.

   Would the Bank of England hike its base rate to strengthen the Pound and combat high oil prices when home prices are tumbling?

This article is just the tip of the iceberg of what's available in the Global Money Trends newsletter. For insightful analysis and predictions of top global stock markets, commodities such as crude oil, copper, the Gold Market, silver and grains – as well as foreign currencies, interest rates and global bond markets – click through here and join GMT now...

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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