The incredible growing oil bubble - Analysts weigh in on crude's rapid rise and who's to blame

The Star-Ledger, June 15th, 2008


English (c) 2008 The Star-Ledger. All rights reserved.

At the height of the dot-com craze, when television commercials were featuring tow-truck drivers buying islands with their tech stock profits and analysts such as Henry Blodget were brashly predicting Amazon would hit $400 a share, Texas financier Richard Rainwater set his sights on oil.

Instead of boarding the dot-com hype train, Rainwater invested $300 million of his own money into energy-company stocks and oil and gas futures. It was one of those "If only I had his crystal ball" moments.

The dot-com bubble, of course, exploded. But oil prices kept climbing - and climbing - netting Rainwater $2 billion in profits and a spot on Forbes magazine's coveted 400 richest Americans list. (He's No. 91.)

But a few weeks ago, shortly after oil hit a record $129 a barrel, Rainwater once again did the unexpected: After an 11-year run, Time magazine reported, he sold all of his oil holdings.

One would think news one of the most successful oil investors of the past decade was jumping ship would be, in Wall Street parlance, "a market moving event." But Rainwater's move barely registered a blip.

It would be like legendary investor Warren Buffett suddenly deciding to dump all his insurance stocks and nobody caring.

Did Rainwater bail out of oil because prices had gotten too frothy? He was not available for comment, but after watching crude's spectacular run-up - doubling to nearly $140 a barrel earlier this month, from a year ago - a lot of smart people on Wall Street are warning prices are being driven not by market fundamentals, but by commodity traders and speculators.

Not everyone agrees.

As gasoline prices top $4 a gallon and Wall Street analysts predict crude could rocket past $200 a barrel by July 4, a debate is raging about why all this is happening.


The oil bulls have long argued there are fundamental reasons for crude oil's meteoric rise: increased demand from China and India, unrest in Nigeria, conflict in the Middle East, increased costs associated with exploration, limited refinement capacities and the falling dollar.

But the role of speculators in the market has come into sharp focus in recent weeks. Congress has held hearings to investigate speculation in commodities, and last week the federal agency that oversees oil trading, the Commodity Futures Trading Commission, held its own hearing to investigate the run-up in oil prices.

So, are consumers paying $50 or more to fill up their gas tanks because of simple supply and demand? Or is there something more ominous - more dot-com like - going on here?

Tim Evans, an energy futures analyst at Citigroup, thinks the spike in oil prices looks a lot like the internet bubble of the late 1990s. And just as dot-com stocks crashed, oil, too, is headed for a fall, he predicts.

"We're seeing a price acceleration on top of a price acceleration," Evans said last week. "I habitually shy away from terms like panic, but I think when prices rise in this kind of fashion, it may be time to reach into the lexicon and pull a word like panic out."

Evans said oil prices have become disconnected from the physical market for petroleum, just as dot-com stocks became unhinged from market fundamentals.

At the height of the tech bubble, stocks of dot-com companies with no earnings, and no prospect of earnings, traded at outrageous prices. The technology-focused Nasdaq market rose 86 percent in 1999 alone. People gave up their day jobs to become day traders.

Now, oil prices, too, have taken on a life of their own, as more and more investors pour billions of dollars into the commodities futures markets, speculating prices will continue to rise.

There are two exchanges that trade oil and other commodities in the United States. One, the New York Mercantile Exchange, or Nymex, is closely regulated. The other, the Intercontinental Exchange, has set up a market in London, where trading takes place beyond the reach of U.S. regulators.

In 2003, approximately $13 billion was invested in oil futures, while today that number has gone up to $260 billion, said Michael Masters, president and founder of Masters Capital, a hedge fund in St. Croix, Virgin Islands, who testified at a recent congressional hearing.


"The demand for Nymex futures and options is exploding, but that is independent of what is going on in the physical market," Evans said. " We are seeing investment flows into the oil market that don't have anything to do with the demand and supply of oil."

In fact, recent industry statistics show demand both within the United States and globally for petroleum actually has been falling, and inventories have been rising as consumers, faced with escalating prices at the pump, use less fuel, said David Edwards, president and portfolio manager at Heron Capital Management.

But it doesn't seem to have any effect on the direction of prices. "The price pattern looks much like the internet stocks index in late 1999, early 2000," he said.

Last week, the International Energy Agency, the energy adviser to 27 industrialized countries, cut its forecast for global oil demand for a fifth consecutive month as record prices continued to erode the amount of petroleum people are using. The Paris-based agency reduced its 2008 forecast by about 70,000 barrels a day, to 86.77 million barrels a day. That leaves demand growth for this year at just 0.9 percent - less than half the growth projected at the start of the year.

In the United States, consumers used 4.3 percent less petroleum in the first quarter of 2008 than they did the year before.

On the supply side, Evans noted the Organization of Petroleum Exporting Countries pumped an average of 32.24 million barrels per day of crude oil in May, an increase of 370,000 from April.

The bottom line: Supply is up, relative demand is down, and yet the price of oil is soaring.

Masters lays the blame squarely on speculators - mainly institutional investors, including corporate and government pension funds, sovereign wealth funds and university endowments.

After the dot-com bubble burst, speculative money pushed home prices to bubble levels. And now that real estate has crashed, the smart money is flowing into commodities.

Masters said over the past five years, investor demand for oil contracts has increased by 848 million barrels - almost equal to China's increase in demand (920 million barrels) over the same time period.

"Institutional investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits," Masters said. "Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.

"Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars and heat their homes?"


Another similarity between today's oil prices and the Nasdaq bubbles: Reckless analyst forecasts despite deteriorating fundamentals, Edwards said.

"The International Energy Agency has announced five straight downward revisions to world demand, yet investment banks are calling for $150 and $250 oil," Edwards said.

Evans said some of the bullish analyst reports coming out these days specifically urge investors to ignore traditional methods of valuation - a common occurrence during the dot-com craze.

"They'll say things like, 'Inventory levels are no longer relevant, or a meaningful measure,'" Evans said. "Except that inventory levels are an objective measure. It's not a matter of opinion - it's factual."

Although no one is predicting oil prices will fall back to $30 per barrel, experts say today's lofty prices are just not sustainable.

Once the current bubble bursts, most experts think the price of crude will settle around $80 or $90 a barrel.

Unfortunately, Edwards is convinced large numbers of investors will pile into the oil market at the 11th hour, just before the bubble bursts.

"We have seen it with internet stocks. . . . We saw it in real estate in 2006," he said. "I can't say for sure if this run-up in prices is going to stop at $160 or $200, but I do know that people that jump in at these lofty levels could get their eyeballs ripped out."

Sam Ali may be reached at or (973) 392-4188.

Graphic Credit: BLOOMBERG

Infobox: "I habitually shy away from terms like panic, but I think when prices rise in this kind of fashion, it may be time to reach into the lexicon and pull a word like panic out."TIM EVANS, CITIGROUP ANALYST

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