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Should We Trade Oil Like It’s 2008 All Over Again?

August 10th, 2011
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http://www.masterjules.net/oilwell.gif by Guest Author Andrew Butter

I suspect that even the most sophisticated student of Econ-101 would concede that the trajectory of the price of oil in 2008 was a bubble and that 2009 was a bust.

However, no one has come up with a convincing theory for what it was that pumped up the bubble or what finally popped it, outside of the old favorites such as…the insanity of crowds, terrorist plots, and Goldman Sachs.

Follow up:

The dynamics of the price in 2011 are eerily similar to what happened then:

andrew-oil-8-10-2011

I have argued previously (a) the “correct” price for oil at this juncture his about $90; (b) that according to Farrell’s 2nd Law the bust will be a mirror of the over-pricing at the top of the bubble…127/90 = 1.41…so the bottom of the bust will be…90/1.41 = $64; (c) the main cause of blowing the bubble in 2011 was the conflict in Libya (d) the “pop” was going to happen on 30th April 2011.

Let’s see what happens next.

Reflecting on the cause of what appears, at least from the current perspective, to have been a bubble and a nascent bust, was probably a combination of the “normal” trigger of too much easy money floating around, combined with the start of the Libyan crisis, exacerbated by the practice of pricing oil on indexes.

That there was easy money, there is no question, although cause and effect was not established in 2008 and not in 2011 either. My guess for the dynamics of how Libya affected the market is as follows:

The start of the conflict took out a (relatively small) component of supply, but it was a special sort of ultra-light oil used mainly by European refiners.

Refiners can’t easily change the grade of their feedstock, so those who were set up to process Libyan oil were obliged to go to the spot market to buy, and since they were European, and Brent is light oil, that’s where they went.

So, the result of supply and demand was that Brent went up.

What happened next is an example of how indexes can mislead the market.  We look at three things:

Brent accounts for less than 1% of all the oil pumped in the world;

Everyone says they follow their own index (WTI, Argus etc), but the reality is that everyone looks over the other guy’s shoulder.

Most oil (and many gas) contracts are linked to an index, so if you buy a couple of super-tankers of oil, the price you pay on delivery is a multiple of an index, with the multiple being determined by the specific quality of the oil.

Thus, if Brent goes up, that can pull up WTI and Argus, and the whole world pays more for oil.

When the Saudi’s correctly noticed that oil was a bubble starting in March 2011 and (they say) they offered up 800,000 barrels of oil a day to replace the lost Libyan oil, they couldn’t find any buyers; that’s because it was the wrong type of oil.

Why Saudi Arabia would want to play “fairy-godmother” is of course another question.  A cynic might well say selling more at the top and less at the bottom, is a good strategy (it is).  A less cynical view is that wild swings in price around the “correct” price doesn’t do anyone any favours except for the speculators who time the swings correctly.  The problem is pointed out in the fundamental Law of Bubbles:  Speculations are zero-sum and for every winner there has to be a loser.  In sustainable economic structures, in most transactions, both sides are winners.

We are in a period of history where governments appear to the casual observer to be peculiarly preoccupied with petty internal squabbles and lining the pockets of the players, whilst missing the Big Picture.  They are preoccupied with borrowing huge sums of money so they can play Rambo.  It is curious that the Saudi’s come across as about the only “grown-ups” around.

Perhaps it might be a good idea to give them a seat on the UN Security Council and kick out France and UK, and replace those two mini-Rambo states with a chair for the EU.   (Errrr…perhaps not, if the EU was on board nothing would ever get decided.)

Equally important, the oil released from the SPR (Strategic Petroleum Reserve) when had little (or no) effect because it got sold at auction, outside of the indexes.  If a much smaller amount of oil had been surreptitiously leaked into the Brent market (what a naughty-naughty idea), that would have made a much bigger difference (for a lot less investment).

So short term, it looks suspiciously like the “market” lost sight of the “fundamental” supply/demand balance again.  (It’s not the first time).

But markets will be markets; they oscillate around the equilibrium, which confusingly changes over time. My estimate of $90 Brent as my guess of the equilibrium may be high if (a) economic activity in the world was affected by the price of oil (which translates into food prices, and business margins - case in point airlines), and (b) the extraordinary spectacle of the dysfunctional US Government throwing it’s toys out of the pram (again), translates into a recession.

Related Articles

Oil:  A Bubble Waiting to Pop or Just Resting by Andrew Butter

Analysis Blog articles on Oil by James D. Hamilton

 


About the Author

Andrew Butter started off in construction in UAE and Saudi Arabia; after the invasion of Kuwait opened Dryland Consultants in partnership with an economist doing primary and secondary research and building econometric models, clients included Bechtel, Unilever, BP, Honda, Emirates Airlines, and Dubai Government.
Split up with partner in 1995 and re-started the firm as ABMC mainly doing strategy, business plans, and valuations of businesses and commercial real estate, initially as a subcontractor for Cushman & Wakefield and later for Moore Stephens. Set up a capability to manage real estate development in Dubai and Abu Dhabi in 2000, typically advised / directed from bare-land to tendering the main construction contract.
Put the unit on ice in 2007 in anticipation of the popping of the Dubai bubble,defensive investment strategies relating to the credit crunch; spent most of 2008 trying to figure out how bubbles work, writing a book called BubbleOmics. Andrew has an MA Cambridge University (Natural Science), and Diploma (Fine Art) Leeds Art College.

 









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