Why the latest oil bubble could be about to burst

From David Stevenson, across the river from the City

Dear Money Morning reader,

Yesterday, oil stood at $63 a barrel. Despite a recent slip, it’s still up by more than a third this year.

We’ve been saying for a while that oil prices are in a bubble, with the cost of crude being shored up mainly by speculators. And that if this reverses, oil could soon fall hard.

But even we’ve not been as gloomy as ex-US government advisor Philip Verleger. Yesterday he forecast the cost of crude collapsing to as low as $20 per barrel by the end of this year.

$20? On the surface, that looks mad. But the closer you look, the more sense his view starts to make. And you might pay more attention when you realise that Verleger also called oil absolutely bang on last year...

What's driving this year's oil rally?

We’re convinced this year’s oil rally hasn’t been driven by how much of the stuff is actually being consumed. It’s been down to a potent mix of investor overconfidence and speculation.

If ever you needed proof about how sharply the oil price can be moved just by some simple punting, the recent ‘rogue trade’ provided it. We talked about this in Money Morning (Why oil looks like the latest bubble), so won’t repeat all the details again. The key point is that a mere $10m speculative, mistaken trade could push up the oil price by a significant amount on its own.

In contrast, the current oil supply and demand picture in the ‘real’ world is… well, rather boring. Oil consumption this year is set to drop by 1.6m barrels a day, said oil cartel Opec last week. Global consumers need 84m barrels a day, a 2% drop on 2008. Meanwhile, the planet’s production has exceeded demand by about 1m barrels a day.

This has led to oil supplies building up, with the Chinese stockpiling particularly hard. And even a small shift in this supply/demand balance can cause quite large changes in oil prices.

But so far, nothing even near the collapse in crude costs to $20 a barrel during 2009 that former-US government adviser and University of Calgary Professor Philip Verleger has just forecast.

Could oil really fall to $20 a barrel?

So what’s his reasoning? Well, he reckons that a 100m barrel crude surplus will build up by the end of this year. Current global storage capacity simply won’t be able to cope, so all the stockpiling will shudder to a halt. Opec may be making record supply cuts of some 2m barrels a day in response to plunging consumption last year, but this doesn’t deter Verleger, who says that “Opec doesn’t realize the magnitude of the cuts it needs to make”.

He believes oil prices would be much lower today but for all that stockpiling. “The economic situation isn’t getting better”, he says. “Global refinery runs” – i.e. producing the likes of petrol – “are going to be much lower in the autumn. If the recession continues and it’s a warm winter, it’s going to be devastating”. The net effect, he believes, will be to send oil prices plunging to levels last seen in February 2002.

This may all sound just too apocalyptic. It’s certainly miles away from consensus thinking. The average City analyst reckons oil will be around the $64 mark in 2009’s fourth quarter, says Bloomberg. Goldman Sachs predicts oil will rally to $85 a barrel by the end of the year. And demand from China, which has just announced annualised GDP growth of 7.9%, is expected to support the oil price.

But Verleger has a good track record. He correctly predicted that oil could go to $150 a barrel in 2008, and last September forecast that prices were heading for a “$50 to $70 world”. That’s been exactly right for the last four months.

And the more you look at his analysis now, the more sense it makes. China’s rapid expansion could be an illusion. As Christian Tegllund Blaabjerg at Saxo Bank says, most of the recent Chinese growth has stemmed from the government’s stimulus package, which has fired up record bank lending. But “the Chinese government is postponing the inevitable”, he says. When “that injection of heavy liquidity” runs out, falling exports will curb the country’s growth rate.

Verleger’s very clear. “China is in a real desperate situation”, he says. “US consumers aren’t consuming and Chinese manufacturers will get hurt. Economists are looking for growth in all the wrong places”.

Then there are those speculators. “Excess speculation needs a constant inflow of new money to sustain prices”, says Jeff Korzenik on Efficient Frontiers. “Just like a Ponzi scheme” – think Bernie Madoff paying off old investors with his latest cash coming in – “needs new funds to keep the game going”.

If oil stocks build up like Verleger believes, and prices start to tumble as demand dries up, much of the cash that’s been chasing the likes of oil could evaporate very quickly. As we pointed out a couple of weeks ago, more money piled into the 1,500 commodity funds tracked by Jennie Byun at JP Morgan Chase in the first half of 2009 than in any previous entire year. But if oil stops being flavour of the month, just watch that money find other homes – fast.

*************
Turning to the markets...

The JSE all share index closed 0.86% up yesterday. The gold mining index slipped 1.64%. Resources added 1.32%. Banks and financials grew 0.17% and 0.36% respectively. Industrials gained 0.12% and the platinum mining index climbed 1.42%.

London's FTSE100 bounced 0.85%. The Dow Jones grew 0.77% and the Nasdaq lost 0.09%.

Tokyo's Nikkei climbed 0.6%. Hong Kong's Hang Seng closed 0.28% up.

Brent crude is currently trading at $66.66 per barrel.

Spot gold's trading at $949.38 and platinum was last quoted at $1182.00.

And here's how the rand is performing against the major currencies:
R/$ 7.84
R/₤ 12.85
R/€ 11.14

Until next week,

David Stevenson

Associate editor, MoneyWeek UK