The new bubble - Oil

Most people here in India, do not know whats going on with Oil Prices. All they know is that their Petrol costs 10% more. And they are pissed off. Driving 20 miles daily on my Bike, I am too. But the distubing part is that - the Indian govt flush with the recent huge tax revenue increases and under the influence of the coming national elections in 2009, has blatantly increased the Oil Subsidy - causing huge long term problems for the Indian economy, and will result in downgrading of its Investment grade rating.

Anyway, this article tries to focus on the reason why Oil prices are increasing on a global scale. What most people do not get is simply this - If the oil demand and supply have not changed, then the simple law of demand and supply should dictate at most a marginal increase in prices to account for inflation maybe. But why are we seeing a 350% increase in under 4 years? Its not like the demand jumped suddenly, or the supply got throttled. (For all those who believe that emerging economies are contributing to the demand increase, note that both china and India consume only a fraction of the world's Oil supply. In fact, in face of the rise in prices, demand has come down multiple percentage points.)

The main problem here is the rampart speculation in the Oil Futures market. Money from Institutional Investors (like Hedge funds) needs to be invested in areas which give good returns. Until the 2001 recession, it was the technology firms, which resulted in the the dotcom bubble and the subsequent slowdown. That money shifted to the next best thing - Real Estate. But when real estate did not give the required returns, the Sub Prime mortgage market with its high risk, high returns profile was tapped, eventually resulting in the Subprime Crisis, which has still not completely blow over. Now the money is looking for a new place to be invested - and Oil is the answer.

So when the amount of money put into the futures market increases 31 fold from $9 billion to $280 billion in 8 years, you know where the problem is coming from. Too much money, giving an illusion of demand.

So what happens next? My guess is as soon as the rate of returns starts to slow down (when the most basic law of economics catches up), money start flowing out to the next area which gets a high rate of return. This will result in a slump in the Oil prices, back to the $80 a barrel level. Unfortunately though, this market is slightly unlike others, in that Oil has a very inelastic demand curve. But with the current prices, the demand will go down, eventually leaving many casualties like the Oil suppliers. (The last time this happened after 1970s Oil crisis - the 8 year Iran-Iraq war broke out, followed by the 1991 Gulf war)

The only silver lining is that - hopefully this crisis will bring to the fore the alternative fuel technologies. But if the US Govt behaves in a shortsighted way, like it did after the 1970s oil crisis, then we set the stage open for another bubble in the future.