Crude Oil Price Falling Off A Cliff, Like September 2008?

By: 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?

Not that anyone 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.

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

I have argued previously (a) the “correct” price for oil at this juncture is 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 the blowing of the bubble in 2011 was the conflict in Libya (d) the “pop” was going to happen on 30th April 2011.

http://www.marketoracle.co.uk/Article24849.html
http://www.marketoracle.co.uk/Article26603.html
http://www.marketoracle.co.uk/Article27857.html
http://www.marketoracle.co.uk/Article27982.html

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:

1: 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.

2: 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.

3: So…supply and demand, Brent went up.

What happened next is an example of how indexes can mislead the market; three things; the first is that Brent accounts for less than 1% of all the oil pumped in the world; second, although everyone says they follow their own index (WTI, Argus etc), the reality is that everyone looks over the other guy’s shoulder.

Third, 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; so 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 fundamental Law of Bubbles is that they are zero-sum, for every winner, there has to be a loser; in sustainable economic structures, in every transaction, both sides are winners.

It’s interesting that 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, and in between borrowing huge sums of money so they can play Rambo, 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 (err…perhaps not, if the EU was on board nothing would ever get decided)?

Equally when the oil was released from the SPR; that 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”, again (it’s not the first time).  

But markets will be markets; they oscillate around the equilibrium, which confusingly changes over time. $90 Brent as my guess of the equilibrium my 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.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2011 Copyright Andrew Butter- All Rights Reserved
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