The latest Barron’s has run a good article against an obvious oil bubble, which is really worth reading. By reaching $135 a barrel from $20ish in 2000, just 8 years ago, the trajectory of oil prices looks very similar to the Nasdaq’s eight-year run to a peak of more than 5,000 in March 2000. Today, Nasdaq sits on ~2,400. Most believe that the hike of oil prices, up 40% simply this year, doesn’t reflects fundamental changes in supply and demand caused by the economy, but by some other factors.

Not surprisingly at all, the biggest hoarders are always the governments across the world. There are several ways for the governments to keep the oil prices high. One is through the government controlled buffer-stock system, which, ironically, is supposed to help ease fluctuations on the free market. In US, it is called the strategic petroleum reserve (SPR). The SPR now holds 705 million barrels of crude, equal to about 35 days of domestic consumption. Thank God that Congress moved in May to stop adding the SPR as it neared capacity. The second way is called government subsidy. In an ideal free market, higher price will curb demand and eventually push the price down. An unrealistically low price simply pushes the price even higher. China raised prices on retail gasoline and diesel fuel by 18% last Thursday. Guess what had happened? The crude price sank the next day. If all the governments follow suit, we will see the price dropping below $100 per barrel soon. The last but not least, the governments should stop maintaining an artificially weak currency. Fed Chairman Ben Bernanke and his colleagues need to understand that weakening the dollar purposely to avoid a sharp price dip in the real estate market simply sacrifices the whole economy, further stimulating the speculation against commodity prices, oil in particular. All the other countries who pegs their currencies with dollar in some degrees need to do the same.

The second largest force include endowments, pension funds and other institutional investors. They employed what so called commodity-indexing strategies, which has topped at $260 billion in March from $13 billion in early 2004, which may control 1 billion barrels of crude. There is also a loophole in the system that lets indexers escape commodity-position limits by purchasing over-the-counter swaps and other derivatives. The triple whammy finishes when the sharp price jack-up forces short-covering by independent oil and gas producers.

All in all, unless governments, especially the US government, start to act towards the right direction, we have to live in a world with ridiculous oil prices. It doesn’t look like that we have a free market for crude oil since governments and big funds have played dominate roles in the market. Common people like us just want to say: bye, oil bubble!

Last 5 posts by Thomas Pan

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