Crude Oil Bubble Trouble

Last week crude oil traded up to yet another record high price above $145 a barrel. Black gold is living up to its nickname, having jumped more than 72% over the past 12-months alone – and up a stunning 631% since the end of 2001!

There’s been much speculation of late about whether or not oil prices are in a “bubble” that’s destined to burst just like China last year, housing a few years before, and internet stocks before that. There are good arguments both pro and con to the oil-bubble notion. Let’s take a closer look…

Fundamental Imbalances Leading to High Prices

There’s no doubt that supply-demand imbalances are playing a very big role in oil’s meteoric rise. Decades of under-investment in new oil production and refining capacity when crude oil prices were low, over the last two decades set the stage for today’s energy crisis.

And many years of above-trend global growth this decade led to a sharp increase in demand from the emerging world. Meanwhile, global production capacity just hasn’t kept pace with the world’s growing thirst for oil.

More recently supply disruptions in Nigeria and Iraq and falling output from Russia, Venezuela, and Mexico – among others – has resulted in very tight global supplies.

Meanwhile, strong demand growth in emerging markets hasn’t let up, partially due to widespread fuel subsidies in many developing nations.

Signs of Excess Speculation in Bubbling Crude

Still, fundamentals may not account for the entire rise in oil prices. According to data from the Commodity Futures Trading Commission (CFTC), speculators have increased their share of outstanding futures contracts to about 70% of the total, up from just 37% in 2000.

Commodity index funds and other pooled investments have poured about $250 billion into commodity trading strategies over the past five years alone. In other words: the hot money is chasing performance in one of the best performing asset classes this decade.

To be sure, some of this increase comes from diversified investment strategies adding commodities to enhance returns. And some of the increase in oil market speculation includes investment firms involved in hedging strategies (going both long and short) for their clients, according to the CFTC.

However, several analysts caution that a big share of the recent run-up in oil is pure speculation, and that prices could correct sharply, closer to the marginal cost of oil production... that’s about $65 to $70 a barrel!

Congress Debates Tighter Regulation, Higher Margin Limits

Now Congress, feeling the heat of higher energy costs, is proposing that the CFTC rein in oil market speculators by, among other things, suggesting a huge increase in margin requirements.

Currently, many investors in crude oil futures get away with putting up initial cash collateral (margin) of just a few percent of the underlying position value.

A $500,000 purchase of crude contracts on margin might cost just $25,000 to $50,000 in cash up front. In the stock market, a trade of similar size would require initial margin of $250,000 in cash.

And that’s exactly what Congress is talking about, raising margin requirements to 50% on futures! They’re also looking into barring pension funds from investing in commodities altogether.

As this debate rages on, one thing is certain, high energy prices are already resulting in “demand destruction” in the U.S. and other developed economies.  In fact, the domestic slowdown already underway will reduce crude oil demand by 240,000 barrels a day this year.

The battle between the oil bulls and bears is really beginning to heat up. It ought to be a good fight with lots of "fireworks".

There are some interesting energy-sector bets you can make that should pay-off in big profits - even with crude oil prices falling. I’ll give you more info in Monday’s blog, so stay tuned.

Have a happy July 4th holiday weekend!