Think Oil's a Bubble? Think Again.

Financial bubbles are nothing new. In the past eight years, the U.S. has been the subject of two severe bubbles that left consumers floored: the dot-com bubble of 2000 and the real estate bubble now suffocating homeowners.

Before that, we suffered through another real estate bubble in the early 1990s and a junk-bond bubble in the 1980s, both of which devastated those gullible enough to get in their way. It's been quite a showcase of natural selection at work.

That's why when the price of oil marches relentlessly higher, it can be easy to cast a weary eye and second guess whether the price is justified, or if we're merely in the grips of the next bubble.

Big bubble trouble
The price of $130-a-barrel oil might be a bubble, but if it is, it's one that looks very different from past bubbles. Speculation and temperament are likely influencing the price of crude, but that alone doesn't guarantee we'll see cheaper prices anytime soon.

For starters, the emotions driving the price of oil are fear and uncertainty. Those are much, much different from the jubilation and clairvoyance that fuel most bubbles. Investors in the dot-com bubble thought they knew everything -- the Internet would take over the world, and nothing could stand in its way. Oil's emotional leverage is completely different: Few people have even the foggiest understanding of exactly how severe the oil crunch will get -- and that promotes fear, not elation.

Numbers don't lie
Even scarier for those hoping the oil bubble will pop soon is that the fundamentals don't necessarily point to anything bubbly at all. For a real bubble to form, supply should exceed demand -- just as the amount of new condos built outstripped the demand of buyers, and the number of Internet companies outstripped the need for new online services. Nothing along those lines has happened in oil. In fact, the opposite is taking hold.

Many reputable oil experts, including billionaire oilman T. Boone Pickens, think current world oil production of 88 million barrels per day is about as good as it gets. When you couple that with demand of 87 million barrels per day and counting, there's only one place for the price to go: up.

Way up, in the case of oil -- those who demand it can't easily reduce their consumption. We've still got to drive to work, fly our planes, and wrap our goods in Styrofoam. When demand outdoes supply and consumers have a tough time cutting back, prices can soar beyond what seems reasonable before things get back in check.

The bottom line, and it ain't pretty
This is all great news for oil giants like ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , and Devon Energy (NYSE: DVN  ) , but it could mean more holes burned in your pockets if you're looking for relief.

While oil's sprint higher seems ridiculous, the thought that we'll return to low prices is pretty far out there, too. For prices to come down there must be either a serious cutback in consumption or a big boost in production -- both pretty unlikely.

Sure, ethanol producers like Archer Daniels Midland (NYSE: ADM  ) and VeraSun Energy (NYSE: VSE  ) are doing all they can to break our addiction to oil, but that topic opens a whole new can of worms.

All things considered, the run up in oil seems warranted. Fear and speculation are playing a role, but by many accounts it's fear backed by some pretty inarguable facts. Call it a bubble if you wish. But don't waste time waiting for it to pop.

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Fool contributor Morgan Housel doesn't own shares in any companies mentioned in this article. He appreciates your questions, comments, and complaints. The Fool's disclosure policy is all about investors writing for investors.


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  • Report this Comment On May 30, 2008, at 5:19 PM, statsguy wrote:

    good observations. one thing that does not quite jive with me- the definition of a bubble as having more supply than demand. I'd argue that during the housing bubble, demand certainly outstripped supply. Yes, the demand came from speculators and people who could not really afford to buy, but it was demand nevertheless. once demand dried up priced then dropped- that represents the time when the bubble is popping. but your points are well taken- supply is not excessive, and demand is tending upward. I do think in 5 years the US will use << oil than today, but what remains to be seen is how demand changes overseas (even though everyone talks about china, it's Russia and the mideast that are growing demand the fastest).

  • Report this Comment On May 31, 2008, at 4:42 AM, rjwince wrote:

    excellent presentation of the facts although I have seen total production to be 85 million barrels daily. Misssing however is the fact that existing wells are drying up at a rate of 6 million barrels yearly (Piickens).

  • Report this Comment On June 19, 2008, at 1:48 PM, insidertrader12 wrote:

    If you think that all the bullish jargin in the rise of oil is not a bubble go ahead and lose your money. This bubble is real and it going to explode not pop. Chinas demand on oil is fake not a true demand subsidizing a large portion of there oil. China is going to reduce the demand on oil by reducing subsidies by 18% roughly. The saudis are going to pump 550,000 more barrels a day to break the bubble and the bubble is mostly speculative in the first place global. The dollars already been making a rebound against the euro. Pull out while you can befor its too late. You are chasing a dream that will turn into a nightmare. Just like the housing bubble. Losses in oil can pull back between 50 and 75 dollars a barrel. Realistic

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