Saturday, May 7, 2011

As Predicted, the Oil Price Reverses

by Andrew Butte

Identifying bubbles is not (very) hard, what’s hard is predicting at what price and when they will pop. Two weeks ago I wrote an article titled “FAO Food Index Predicting a Reversal in Crude Oil Prices”. I’d say a 15% decline in Brent from $127 to $110 qualifies as a “reversal”. Outside of noticing that food prices slightly lead oil prices, the logic behind that argument was:

1: The Libya thing was a Red Herring used by the speculators to instill a bit of panic into the market; there never was a short-fall of oil compared to demand (short-term) and there still isn’t.

2: The Saudi’s might have a sulk about what they perceived as misinformed and impolite comments from various corners of the US Administration about the human rights of minorities and all that baloney. But ultimately, they know that the alternative to sucking up to America (making sure oil does not get too expensive for America’s taste), is not an option, and they know America knows that and America knows they know America knows that. Perhaps it wasn’t a coincidence that oil prices tanked soon after Osama bin Laden was in the news (hopefully for the last time), and as that subject hit the headlines, memories were jogged that 14 out of the 19 terrorists in 9/11 were Saudi’s?

3: The correct price of oil right now valued according to what the world can afford to pay (without suffering unduly), is about $90 (Brent). So at $127 oil was a 40% bubble, bubbles do have a habit of popping once they get to 40% over the “fundamental”.

Where Next?

Well, according to the theory, if oil was 40% too high, and if no one is taking the spectre of peak oil too seriously (in which case the “fundamental” value is the replacement cost (i.e. what it will cost to find and produce more oil)), then at some point in the not-too distant future the price of oil “ought” to explore $90/1.4 = $64 (Brent). Whether it does or not, will be a good test of how much the “Peak Oil” idea is gaining traction.

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