Get Ready for a Big Oil Bubble

Over the past two decades the U.S. economy has gone through a series of bubbles that inflated for a while, creating real wealth for some and a sense of prosperity for others, and then burst, taking investors to the cleaners. If those bubbles were caused by easy money and lax oversight, as many economists believe, there is no reason to expect the outcome to be different in the future, especially since the United States now also runs a massive structural budget deficit.

What will be the next bubble to inflate and burst, then? Will it hit U.S. Treasuries, which after years of record prices have lost ground recently, with the yield on the 10-year bond going up to 3%? Or will it hit “undefaultable” student loans, of which the federal government holds over $1 trillion, adding more than $100 billion every year?

My own guess is that the next bubble will happen in oil. Oil prices reached a bubble stage briefly just before the financial crisis, coming close to $150 per barrel in mid-2008. It didn’t take long for prices to retreat, but the spike exacerbated problems in the housing market and the subsequent financial meltdown. Oil prices then plunged by 60% in eight months.

Emerging and Thirsty

Oil prices recovered quickly in 2009, largely because the Chinese economy continued to expand even as rich industrial economies went into a recession. Since 2008, the number of cars and trucks on Chinese roads jumped by a nearly 100 million, a stunning figure considering that the entire U.S. fleet comes up to 240 million motor vehicles. Industrial growth in China also created a boom in commodity producing economies such as Brazil, Australia and parts of Africa, all of which contributed to rising worldwide demand for oil.

Moreover, the dollar was weak throughout that period. Since oil is priced in dollars, stronger domestic currencies in many countries meant that local motorists were shielded from the impact of more expensive oil. Indiain particular enjoyed a boom in auto sales, in large part because the local currency, the rupee, was appreciating rapidly against the greenback.

Now many of the forces that stimulated oil consumption after 2009 have gone in reverse. The Chinese economy has slowed and, even if more recent figures point to a new acceleration, the government continues to discourage its people from buying and driving cars, given massive pollution and traffic congestion problems in the country’s major cities. Car ownership inChinais growing, but it’s no longer exploding. Meanwhile, the rapidly growing economies of India, Brazil and Russia—the other BRIC countries—have flagged and their currencies have weakened against the dollar in light of the imminent monetary policy tightening by the Federal Reserve.

One bright spot for the auto industry has been theUnited States, but rising U.S. auto sales are probably a net negative from the point of view of oil demand. The average car on the road in theU.S.is now 11.4 years old, a record. As Americans hit the showrooms, they merely replace their old clunkers with far more energy-efficient modern vehicles. If auto sales pick up inEurope, where they fell to a 20-year low earlier this year, the effect may be the same, cutting demand for gasoline rather than spurring it.

Persistently high oil prices over the past decade and a half have encouraged conservation efforts and prompted users to switch to less costly energy sources, especially to natural gas, which has become cheaper due to the fracking revolution. Since 1985, the measure of oil efficiency of theU.S.economy, the dollar amount of GDP it produces per barrel of oil, has increased by more than 50%. An indirect measure of energy efficiency is found in profit margins for S&P 500 companies: They have been hovering near their historic highs and now stand at 9.3%, despite high oil prices that should have theoretically boosted their costs.