The problem with the oil bubble...

Some observers are starting to chance predictions of a collapse in oil prices, but is it really a "bubble"?

Oil prices climbed to their highest level ever, reaching over $108 per barrel this week. And Americans are feeling this price spike at the pump, with gasoline averaging $3.22 per gallon. An analysis released by the investment firm Goldman Sachs suggested that oil prices might soar to $200 per barrel. Does this make sense?

Not really. Although U.S. crude oil inventories have fallen, gasoline inventories are at their highest since March, 1993, notes Tim Evans, an energy futures analyst at Citigroup's Futures Perspective. World oil production was up 2.5 percent in the first quarter of 2008 over the same period in 2007 while world oil consumption rose by just 2 percent. In fact, world production is projected to be 3.3 percent higher in the second quarter and 4.1 percent higher in the third quarter than the same periods a year ago. On the other hand, world demand is projected to rise by just 1.6 percent over the next six months. [More]

Bailey, with whom I usually agree wrote this in early March - and already it looks wobbly. He is not alone. In my commentary last week on USFR I mentioned that the oil fundamentals seem to have less effect on price than before. One reason I suggest for this apparent flaunting of fundamental market economics is the delay factor allowed by dwindling but still-ample credit. We'll change habits only after our cards are maxed out.

One viewer added a salient - however unsettling point:

With respect to your commentary at the end of the first segment this past
week, the law of supply and demand says that as price rises demand only
drops when price exceeds the equilibrium price. Perhaps the equilibrium
price has not yet been met.

If true, and the equilibrium price is still somewhere above current prices, what the heck is going on? Many folks put it down to speculators, but this effect cannot last forever. Sooner or later, they want their price-boosting investments dollars back. This is the great cry from those looking backwards to historic price actions, but again, the identification of a speculative bubble is not universal.

“The Oil Bubble: Set to Burst?” That was the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse.

Ten months later, oil was selling for $70 a barrel. “It’s a huge bubble,” declared Steve Forbes, the publisher, who warned that the coming crash in oil prices would make the popping of the technology bubble “look like a picnic.”

All through oil’s five-year price surge, which has taken it from $25 a barrel to last week’s close above $125, there have been many voices declaring that it’s all a bubble, unsupported by the fundamentals of supply and demand.

So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble? [More][Tyler Cowen comments here]

But part of that analysis rests on the demand for gasoline being the key to oil demand. That seemingly basic fact is more in doubt than before, as farmers everywhere are discovering with every fuel load.

Meanwhile Murti says demand for middle distillates, like diesel, gasoil, heating oil and jet fuel and kerosene is racing up. The difference in prices between gasoline and middle distillates, known as a crack spread, has been exceptionally strong signaling tightness in global refining capacity.

Just a year ago US RBOB spot gasoline prices were worth some $92.60 per barrel while NWE jet was priced in at some $83.3, a discount of over $9 per barrel. Today that same jet fuel is nearly $30 more expensive than RBOB, and has led to U.S. refinery Valero switching production by up to 7 percent from gasoline to gasoil.

Murti attributes that strength to resilient non-OECD demand growth as well as numerous global power problems, all of which have led to increased usage of diesel and gasoil-fired generators. [More]

If true, watching US car sales pattern shifts and driving habits may not be the best way to gauge demand. Moreover, it a key difference between today's energy economics and other oil price spikes. If industrial activity takes over (thanks to expanding global economies) from consumer use as the demand leader, will old price patterns hold? I think not.

One key will be to watch to see if the spread between diesel and gas widens. Until refineries change the distillate output mix, we could see some strange disconnects between gas and oil prices.

And some blistering diesel costs.