From the August 2008 issue of Research Magazine • Subscribe!

August 1, 2008

The Oil 'Bubble'

West Texas Intermediate Crude Oil (WTI), as measured by the United States Oil Fund (USO) has doubled in the past 12 months. Investors and consumers, in fact an entire nation is hoping that the recent spike in oil prices will behave like a bubble and do what bubbles do best ... burst.

In the past decade, we've become accustomed to different kind of bubbles. First was the technology bubble that burst in 2000 and just recently the house-and mortgage bubble blew up. Next is the oil bubble, right? Aside from the soaring price, oil is missing some of the main characteristics of a bubble.

Bubbles occur when something is obviously overprices for nor apparent reason. A dot-com stock with no earnings and a $10 billion market cap or an 800-square-foot shoebox with a view of the highway and a $1 million price tag do smell like a bubble. Both overly inflated markets were "home-grown;" prices were driven up by the average Joe who was afraid of being left out. A bubble cannot swell without the public's involvement.

There are fundamental reasons for $110-plus/barrel oil. (1) A weak U.S. dollar: Some researchers suggest that oil would be trading around $80/barrel if the dollar were still at 2001 levels. (2) Increasing demand: Emerging economies like India and China have developed a thirst for oil only rivaled by the U.S. (3) Decreasing supply: The easy oil is almost gone. Extracting the black gold is more time-and cost intensive now than it was a decade ago. (4) Political unrest in oil-producing regions: Oil-producing countries seem prone to some political turmoil (Venezuela, Nigeria and Iran).

The geo-political issues many top oil-producers are faced with must contribute to the fact that the energy sector of the S&P 500, represented by the Energy Select Sector SPDRs (XLE) is essentially flat for the year, while crude oil has gone up about 50 percent year-to-date. While the facts don't support the notion of an oil bubble, we will be able to expect a pullback partially to digest the recent gains and because oil historically consolidated in September as the driving and hurricane season wind down.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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