Oil: What Goes Up Must Come Down

07/14/2008 12:00 am EST

Focus: MARKETS

John Dessauer

President, John Dessauer Investments, Inc.

John Dessauer, editor of John Dessauer’s Inverstors’ World, says there’s a bubble in oil and prices will fall even though many people say it can’t happen.

There is growing concern that oil and other commodities have disconnected from their underlying fundamentals because of massive trading in commodity indexes and other commodity-related instruments.

My view is that we definitely have a bubble in oil and in many other commodities, too. These bubbles are created by huge pools of money searching for high returns. Investment flows surge like a flood. When they reach a breaking point, they burst and flow into another market. Flows can run in one direction for a long time, but when they reach their limit, prices can come down hard. What happened to tech stocks and real estate can happen to other markets.

In 1998, there was an oil glut because demand was well below the supply. That drove the price to under $11 a barrel, an overshoot on the downside. In March 1999, The Economistran a dramatic article headlined “Drowning in Oil.” The oil price had fallen from a 1981 high of $44 a barrel to nearly $10 in late 1998. The Economistargued that oil would stay cheap for a very long time, falling to $5 a barrel. Here we are, not quite ten years later, and oil is $140 a barrel, and headlines herald the opposite conclusion, “The end of cheap oil.”

What changed most dramatically is our view of the oil market and our expectations for the future. In 1999 the popular perception was that demand would stay weak. Today’s conviction is the exact opposite. We see never-ending growth in demand no matter what the price.

The number-one lesson from the past is that price matters. Cheap oil resulted in higher demand. The surge to $140 will more than likely cause lower demand growth. Not only will demand growth cool, but supplies could expand more than are now expected. Cooling demand and rising supplies should change the oil price psychology.

There could be totally unexpected consequences as well. Governments from emerging Asian markets are rethinking their subsidy policies. Subsidizing consumer prices is threatening government budgets. An even greater risk is that by suppressing prices now, they keep demand artificially high and set the stage for a much bigger price jump for consumers.

The oil bubble will eventually burst. Prices will go down and stay down. It is impossible to know when. But it looks like we are getting close to the tipping point. It is impossible to know how far down the price will go before finding the next bottom. A price below $100 is likely. After that, we will live with the risk that oil can surge again if demand grows faster than supplies.

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