CRUDE OIL BUBBLE: IS IT A CASE OF " IRRATIONAL EXUBERANCE"?

The recent gravity defying surge in Crude Oil has attracted much attention and generated heated debate across the globe. A 99% annual appreciation in prices of world's principal source of fuel is bound to affect all countries and their inhabitants in a big way. The situation is even worse at MCX, India, where a depreciating rupee (against dollar) has further added momentum to the rally as a stronger dollar directly translates to costlier imports (read Crude Oil). In my previous posts in the same blog and numerous articles, presentations, lectures and private discussions, I had reiterated that the era of "Easy/Cheap" oil is over. However, the way the Crude Oil is scaling newer highs each day has put analysts across the world in a fix. It is not the $130 or $135 level which is alarming us but the speed with which these milestones are being achieved.

Market is equally divided between those who are seeing further upside and between those who are expecting a substantial correction in near term.

The reasons for a deeper correction/profit booking in Crude Oil are numerous.

There are many reasons to assume that market is overreacting to Oil bullish factors. What is being ignored is the fact that Commodity business is a cyclical one. Higher Crude Oil prices (or any other commodity) are self defeating as it directly translates into a reduction in demand as the consumers start cutting down on consumption or switches to cheaper alternative. Arjun Murti of Goldman Sachs who has to his credit many doomsday prophecies (including the recent Crude at $ 200 one) himself drives in a Hybrid car.

Many banks and investment firms have come out to defend the rise in oil prices, saying that it is based on fundamentals and that prices could rise much further. Analysts like Arjun Murti, Pickens, Guppy etc. and market movers like Goldman Sachs, UBS are constantly raising the projection levels in prices, thus sending the prices over the roof. While they go on saying this and prices continues to move upward, open interest in crude futures contracts has been moving steadily downward since a high of 1.58 million last July to 1.36 million now.

But aren't there fundamental reasons for this rise in oil prices? In some ways yes, demand from China and India is increasing, but at a slower pace than oil has gone up. The chief market strategist for one of the world's leading oil industry banks, David Kelly, of J.P. Morgan Funds, recently admitted something telling to the Washington Post, "One of the things I think is very important to realize is that the growth in the world oil consumption is not that strong." One of the stories used to support the oil futures speculators is the allegation that China 's oil import thirst is exploding out of control, driving shortages in the supply-demand equilibrium. The facts do not support the China demand thesis however. The US Government's Energy Information Administration (EIA) in its most recent monthly Short Term Energy Outlook report, concluded that US oil demand is expected to decline by 190,000 b/d in 2008. That is mainly owing to the deepening economic recession. Chinese consumption, the EIA says, far from exploding, is expected to rise this year by only 400,000 barrels a day. That is hardly the "surging oil demand" blamed on China in the media. Last year China imported 3.2 million barrels per day, and its estimated usage was around 7 million b/d total. The US , by contrast, consumes around 20.7 million b/d. That means the key oil consuming nation, the USA, is experiencing a significant drop in demand. China, which consumes only a third of the oil the US does, will see a minor rise in import demand compared with the total daily world oil output of some 84 million barrels, less than half of a percent of the total demand. The Organization of the Petroleum Exporting Countries (OPEC) has its 2008 global oil demand growth forecast unchanged at 1.2 mm bpd, as slowing economic growth in the industrialised world is offset by slightly growing consumption in developing nations. OPEC predicts global oil demand in 2008 will average 87 million bpd -- largely unchanged from its previous estimate. Demand from China , the Middle East , India , and Latin America -- is forecast to be stronger but the EU and North American demand will be lower.

Not only is there no supply crisis to justify such a price bubble. There are several giant new oil fields due to begin production over the course of 2008 to further add to supply.


The world's single largest oil producer, Saudi Arabia is finalizing plans to boost drilling activity by a third and increase investments by 40 %. Saudi Aramco's plan, which runs from 2009 to 2013, is expected to be approved by the company's board and the Oil Ministry this month. The Kingdom is in the midst of a $ 50 billion oil production expansion plan to meet growing demand in Asia and other emerging markets. The Kingdom is expected to boost its pumping capacity to a total of 12.5 mm bpd by next year, up about 11 % from current capacity of 11.3 mm bpd. In April this year Saudi Arabia 's Khursaniyah oilfield began pumping and will soon add another 500,000 bpd to world oil supply of high grade Arabian Light crude. As well, another Saudi expansion project, the Khurais oilfield development, is the largest of Saudi Aramco projects that will boost the production capacity of Saudi oilfields from 11.3 million bpd to 12.5 million bpd by 2009. Khurais is planned to add another 1.2 million bpd of high-quality Arabian light crude to Saudi Arabia 's export capacity.

Brazil 's Petrobras is in the early phase of exploiting what it estimates are newly confirmed oil reserves offshore in its Tupi field that could be as great or greater than the North Sea . Petrobras, says the new ultra-deep Tupi field could hold as much as 8 billion barrels of recoverable light crude. When online in a few years it is expected to put Brazil among the world's "top 10" oil producers, between those of Nigeria and those of Venezuela .


In the United States, aside from rumors that the big oil companies have been deliberately sitting on vast new reserves in Alaska for fear that the prices of recent years would plunge on over-supply, the US Geological Survey (USGS) recently issued a report that confirmed major new oil reserves in an area called the Bakken, which stretches across North Dakota, Montana and south-eastern Saskatchewan. The USGS estimates up to 3.65 billion barrels of oil in the Bakken. These are just several confirmations of large new oil reserves to be exploited. Iraq , where the Anglo-American Big Four oil majors are salivating to get their hands on the unexplored fields, is believed to hold oil reserves second only to Saudi Arabia . Much of the world has yet to be explored for oil. At prices above $60 a barrel huge new potentials become economic. The major problem faced by Big Oil is not finding replacement oil but keeping the lid on world oil finds in order to maintain present exorbitant prices. Here they have some help from Wall Street banks and the two major oil trade exchanges—NYMEX and London-Atlanta's ICE and ICE Futures.

Moreover, the argument that Crude Oil is tracking a weaker dollar doesn't hold true anymore. Euro has corrected sharply from its high of 1.6018 against the dollar. Signs of slowdown are being identified in Eurozone as well and ECB's Trichet has come under pressure to review his tight monetary policy. On the other hand recently released US economic indicators and have been largely mixed and point towards relative stabilization of Housing and labor market. Moreover with commodity prices going over the roof, US Federal Reserve may soon return to the policy of Inflation targeting. Interest-rate futures show the Federal Reserve may start to raise U.S. borrowing costs by the end of the year as the economy recovers and inflation accelerates. Earlier, seven interest-rate cuts by the Fed since September sent the dollar to an all-time low against the euro in April, boosting gold and other commodities.

Moreover, Crude Oil being a political (and strategic) commodity, we may very well see intervention from US on the issue of high prices. Entire global economy, especially that of US is under strong pressure due to Crude Oil induced inflation. Recently, the US House of Representatives overwhelmingly approved legislation allowing the Justice Department to sue OPEC members for limiting oil supplies and working together to set crude price. Already, President Bush in his recent trip to Gulf has pressurised Saudi Arabia, the most influential OPEC member to increase the Crude Oil production by 300,000 million barrels per day. Also, if recent indications are to be believed, U.S. Government is soon expected to force regulators to raise margin requirements under current market conditions, specifically with respect to the oil markets. This could have a dramatic downward effect on prices. (Remember silver and the Hunt Brothers in 1980.) In April 2008, U.S. Sen. Byron Dorgan, a North Dakota Democrat, told Congress, "There is an orgy of speculation in futures markets. This is a 24-hour casino with unbelievable speculation." He and others in Congress have been raising the idea of changing margin requirements that traders must pay up front in order to engage in oil speculation. Dorgan said stock speculation requires a 50% margin, but commodities like oil demand a much lower threshold, just 5% or 7%.

No doubt, Crude Oil, being in limited supply, is fundamentally strongest commodity around. But the way the recent spike has pushed the prices of the liquid gold has raised many an eyebrow and in coming days we may expect a substantial correction. Though a break below $100 is certainly not anticipated and too far fetched, a correction to the tune of $ 20 from current levels cannot be ruled out. However, traders should refrain from taking a short position arbitrarily and should wait for the confirming trend. Like any other market analysts, I too have faith in the old adage "Market is always right" and "Trend is your friend".

Courtsey:salmanspeaks.co.nr

Is there a Commodities Bubble - Lehman Brothers

With due apologies to Commodity Bulls like Jim Rogers, we might have just created a monstrous bubble that will blow away off its own weight, says a study by Lehman.

The reasons are simple, 40 feet containers carrying Bulk Loads from Chinese ports to Eastern North American ports, now cost $ 8000, up from $ 3000 last year. If Crude were to go to $ 200 per barrels as most analysts now agree, this fare will rise to $ 20,000.

The result; increased domestic production in the US, reduction in trans China-US bulk trade and possible stress on pan Asian Commodity trade.

Simply speaking, the Commodities bubble is unsustainable and will collapse under its own stress. If not, there cannot be a one-sided move in Commodity prices without that being reflected in the fundamentals of Commodity producers.

-Commodity index investors bypass speculator position limits set by the CFTC
-About $90 billion has flowed into commodity indices since 2006
-Commodity markets are much smaller and illiquid compared with equities & bonds
-Dollar weakness and inflation expectations are behind fund inflows and this causes a substantial price effect for some commodities.
-Fundamental loosening can be disguised by Saudi Arabia and China.
-Equities go up long-term with human progress; not always true for commodities

Past performance, dollar weakness, and inflation expectations have driven substantial financial inflows to commodity indices, potentially feeding into higher prices.

~Financial Inflows to Commodities

Oil prices this week reached all-time highs above $125/bbl, topping off a $50+ run-up since September 2007, perhaps the most visible increase of the across-the-board rise in commodity prices.

A fierce debate has erupted over the permanence of this bull run: some analysts argue that the massive price increases are the rational market response to tight supply-demand fundamentals, while others point to speculator activity as proof of its bubble-esque nature.

The debate also carries a political dimension, as OPEC has resisted calls to increase production by blaming speculators for rising prices.

Undoubtedly, financial investors have made huge commodity investments in the past five years. One channel for this flow has been commodity indices such as the GSCI and the DJ-AIG Commodity Index. These indices bypass traditional speculative position limits imposed by CFTC regulations, allowing pension funds and other investors to assume massive long positions in hitherto untouchable markets.

It is difficult to ascertain the exact size and effect of these indices, but based on their known positions in certain commodities and their reported cross-commodity weightings, one can estimate their overall size.

We estimate that total assets under management (AUM) in commodity indices ballooned from about $70 billion at the beginning of 2006 to $235 billion by mid-April this year (Figure 1). Of this $165 billion increase, about $90 billion is accounted for by financial inflows into these indices, with the other $75 billion stemming from price appreciation of the original underlying investment.

These figures may seem miniscule compared with the trillions of dollars sloshing around in global bond and equity markets, but commodity markets are comparatively small and illiquid. Even a $1 million inflow, as we shall see, can have a major effect in certain commodities.

Inflows have seen a major spike since December last year, with the lion's share of the contribution coming from the energy-heavy GSCI index.

What Causes Index Inflows?
Financial investment in commodities is commonly considered a hedge against two concerns: dollar weakness and inflation. Another reason might be a general flight away from the underperformance of more traditional asset classes such as equities.

Regressing our estimates of financial inflow against past 1-week returns on the dollar and breakeven inflation on 5-year T-notes, we find that dollar weakness and breakeven inflation indeed predict inflows for both GSCI and DJ-AIG, both at high levels of significance.

We also find that underperformance of the S&P also predicts inflow, although at weak significance levels (Figure 3). But perhaps most interesting, we find that the performance of the GSCI and the DJ-AIG over the past month also strongly predict inflows to the indices, suggesting a significant amount of momentum-chasing.

Do Index Inflows Affect Prices?
Given these substantial financial inflows to commodity indices, can we measure their effect on prices? Unfortunately, this analysis presents considerably higher obstacles. Ideally, we would want to measure the true liquidity-adjusted inflow to capture the true market impact, but outside noise from fundamentals, the annual reweighting of the indices, and unobserved over-the-counter activity cloud the picture.

There seems to be substantial variation in the market impact of index inflows across commodities, likely because of differences in liquidity. For WTI, a relatively large and liquid market, a $100 million inflow appears to cause a +1.6% rise in price at the 0.1% level ofsignificance, whereas a $1 million inflow alone into cocoa appears to cause a 3.2% price jump.

Furthermore, inflows to the GSCI seem to have a substantially higher effect on commodity prices than similar inflows to the DJ-AIG index, possibly reflecting the higher share of GSCI-mimicking lookalikes in the index universe.

Ingredients of a Bubble
Given the aforementioned causes and effects of financial inflows, we see many of the essential ingredients for a classic asset bubble. Performance-chasing financial inflows to commodities cause prices to rise, thus delivering good performance and, in turn, attracting even more inflows. This phenomenon can be self-fulfilling, especially in an environment in which lack of information about the true state of inventories in China or spare production capacity in Saudi Arabia delays any fundamental market correction.

But in the buzz around commodities, investors may have forgotten the obvious:
Commodities are inherently cyclical assets whose prices fluctuate around some longterm (but potentially changing) equilibrium level, while equities are shares in the future cash flow of dynamic firms providing long-term returns from technological progress.

For commodities, technological progress increases both demand and supply, making long-term price appreciation, even for non-renewable commodities, uncertain at best. Adjustment to a higher equilibrium price may mimic superior returns in the short term, but they are unlikely to last forever.

The Glittering Run For Gold Is Over!!! UBS

Gold has benefited from dollar strength and investor and speculator buying due to fears of stagflation and the impact of the credit crunch. We forecast that gold will fall over the next two years to levels better supported by jewellery demand.

We forecast that gold will average $851/oz in 2008, higher than our previous forecast due to the better than expected Q1-08 outcome. Our forecast of $750/oz for 2009 is unchanged.

The consensus forecast is for gold to average $862.30/oz according to the LBMA forecast 2008 publication.

Performance
Speculative and investment buying resulted in gold trading sharply higher in January and February, breaking the previous all-time high of $850/oz in the first real trading day of 2008 and then going on to set records, culminating in a new all-time high of $1030/oz.

But gold could not hold onto these lofty levels and slipped back to trade down to $874/oz. After a bounce to just above $950/oz in

April, the metal has succumbed to more widespread profit taking and is trading around $880/oz at the time of writing.

In the absence of the unusually strong safe-haven buying of gold we believe gold would be trading near $700/oz and the metal is vulnerable to a further correction.

Demand environment
The first three months of 2008 saw very poor jewellery demand as gold moved sharply higher with our sales desks report jewellery demand of 5-15% of the levels we consider strong. The sell-off in gold in late March has seen some recovery but demand remains much lighter than normal for the time of the year and this leaves the metal vulnerable to further profit taking.

ETF investors bought only 2.0 million ounces of gold in the first quarter of 2008, disappointing considering the very strong performance of gold. Net redemptions have occurred since then and as at 24 April, total ETF positions stood only 600koz higher than on December 31st with 1.6moz of redemptions between 22 and 24 April.

US futures market gold investors held large spec long positions through the first ten weeks of 2008 before liquidating some of their holdings in late March and April.

Supply environment
GFMS report that gold production fell by 0.4% in 2007 to 2,476t as mining companies struggle to maintain existing production and are failing to find new mines to expand. We expect gold supply will remain under pressure in 2008, not least because of the power and other production problems faced by the South African mining industry, discussed in more detail in the introduction to the precious metals section.

Our refinery contacts and physical sales desks in Switzerland report a surge in the sale of scrap gold coming back to the market with the gold price at such elevated levels. This is reducing the jewellery industry¡¯s net demand for gold.

Gold mining de-hedging continued at a rapid pace in 2007 according to GFMS, which estimates the net hedgebook declined by a record 446t. The remnant of the global hedgebook is now small to GFMS and increasingly concentrated in a only a few mining companies. We expect the rate of producer de-hedging to slow in 2008, but we have said that every year for the past few years and have been surprised by aggressive buy-backs each year.

Central banks remain net sellers of gold, disposing of a total of 481t in 2007, more than the 370t sold in 2006. The vast majority of the sales in both years came from the signatories of the Central Bank Gold Agreement (CBGA) with Spain and Switzerland the most interesting sellers. Spanish sales increased sharply in 2007 while Switzerland, a large seller under the first CBGA, restarted sales due to the high gold price, which had increased gold¡¯s proportion of its total reserves.

Some small central bank buying was noted in 2007 including Qatar and Russia, although most large central banks that have small gold holdings remained sidelined.

News-flow to watch for
The quarterly results of the gold miners with hedgebooks ¨C including AngloGoldAshanti, Barrick and Newcrest ¨C for signs of further de-hedging.

Weekly COTR data from the CFTC and daily open interest figures from
TOCOM are useful measures of visible speculative positioning.

Quarterly supply and demand reports from the World Gold Council.

Captilizaing on Commodities Bubble-Michael Shluman

There's a black cloud looming over the commodities market. However, behind that cloud, those of us who are situated on the short side (that is, buying put options and profiting when stocks are going down) can expect to find a rainbow with a pot of gold at the end.

I know, I know: Wheat is up 600% a bushel. Oil touched an inflation-adjusted, all-time high and seems as though it's setting up permanent residence above $100 a barrel. Gold prices were a straight tear up (although a recovery in the U.S. dollar has helped capped them).

I can hear you now: "There's no way to play the short side of the commodities sector, Shulman."

Longer term, there's every reason to believe that commodity prices will be high and perhaps go even higher. You might have heard a lot about growing infrastructure and demand in areas like "Chindia" (i.e., China and India) and other developing nations.

With this boom will come increased need for food, building materials and energy sources. As emerging countries become more industrial, it is only natural that more jobs will be generated, leading to a higher standard of living and even more commodity consumption.

That's the big-picture outlook. But with a slowing U.S. economy and its carryover into the global community, not to mention the fact that the big-money players (i.e., institutions, hedge funds) are piling into commodities and inflating the prices with their speculative buying, what does it mean for us in the short term and, more specifically, on the short side?

Even as the economy seems to be taking a rest, commodities are likely going to pull back before they keep going up, up and away. This bubble is building.

In some commodities, there's a classic parabolic bubble, which is a short-side investor's dream.

Perhaps gold can run to $1,600, as "Mad" man Jim Cramer thinks -- but will wheat remain near their high of $25?

Will a fertilizer and feed producer -- which is on my "short" list of companies that are going to get hit when the commodities bubble starts deflating -- manage to stay in the stratosphere? Will platinum keep shooting skyward?

Smart short-side investors need to identify the commodities that are driven by economic reality and look for places to establish short-side plays for the commodities or companies on a free ride with the run-up in prices. There are plenty, but there are also some rules to follow:

Rule 1: Don't get ahead of the bubble bursting. It's better to miss the beginning than get run over by being too early.

Rule 2: Focus on those commodities most tied to economic reality.

Rule 3: Avoid commodities that are potentially driven by geopolitical events.

Rule 4: See rule No. 1.

So, how do you profit while commodities are poised for a pullback? There are two main areas I'm investigating right now.

The first is agricultural commodities. There's no way that wheat will stay at $25 (up from $4 last year), or that a company we're riding on will remain around $160 (up from $60 just one year ago!).

There are several exchange-traded funds (ETFs) and several overbought companies in this sector, so I am looking at them carefully right now. I also have a close eye on precious metals other than gold -- namely, platinum and silver. This segment can also be played by a mixture of ETFs and individual companies.

But for every opportunity, there is a sinkhole, and I can tell you what I will not be shorting.

Gold. Avoid playing the short side of gold at all costs. It is tied to the U.S. dollar and geopolitical issues -- and just possibly to the people who built bomb shelters in the '60s and their offspring who created hideaways in preparation for Y2K.

Oil. The fundamentals show that oil prices will rise because they are also tied to the dollar and geopolitical events. Stay far, far away.

In general, I'm keeping anything that is tied to the U.S. dollar -- or other factors beyond the segment that can change on a dime and decimate a play -- far from my "short" list.

But remember, you can play the short-side of individual stocks, sectors and, soon, commodities -- and you should.