Friday, May 2, 2008: Issue #791

Is Oil Becoming the “Mother of All Bubbles?”

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club

Dear Investment U Reader,

We've all heard the story . . .

Most of the world's major oil deposits have already been discovered. The low-hanging fruit has been picked. The remaining oil supplies are tough to get at – and expensive to recover.

Meanwhile, the world's demand for oil keeps rising as more people around the globe – especially in emerging giants like India and China – set up factories, buy cars, take flights, heat their homes, and pound the table for "more juice."

Then there are political question marks. Iraq is a mess. Russia is inclined to use its resource exports as a carrot or a stick, depending on the mood. And Nigeria is a special basket case.

Last week, for instance, an escalation in attacks by militants in the Niger Delta sent oil to a record close. Exxon has said the situation is so bad that its production is now closed and it is unable to meet its contractual obligations.

Royal Dutch and other Western oil companies there have the same problem. Not good. Nigeria is Africa's largest producer and the world's eleventh biggest.

No wonder oil is trading near $120 a barrel.

This is the back story. But it's important to understand that it is only that, a story. It doesn't tell us where oil should be trading. Ultimately, that will be decided by supply and demand, not by this week's headlines or short-term speculation.

A lot of smart people are beginning to believe this bull market will die hard. Whether you agree or not, it's worth listening to their side.

According to Michael Lynch, President of Strategic Energy & Economic Research, oil has now become "the mother of all bubbles." He has a few pertinent facts on his side.

The U.S. is the world's largest oil consumer. Yet our economy is in a slump. Despite the sharp rise in oil prices this year, oil demand in the U.S. is actually down 2% so far.

According to the federal Energy Information Administration, high prices and a weak economy will knock down U.S. oil consumption by 90,000 barrels a day this year.

The situation is similar in many other parts of the world. The International Energy Agency (IEA), the Paris-based energy watchdog of the world's richest nations, just lowered its forecast for world oil demand growth by 460,000 barrels a day. The IEA also sees supply from outside OPEC growing by 815,000 barrels a day, the strongest growth since 2004.

According to Mr. Lynch, "The run-up in price we're seeing in the last six weeks or so has happened while the fundamentals have, generally speaking, gotten bearish."

Tim Evans, an energy analyst at Citigroup in New York, agrees. He says the oil bubble is "still expanding" and insists "there is no supply-demand" deficit.

So far the futures market has shrugged off these arguments. Oil is up roughly 25% this year and prices have almost doubled since the start of 2007.

And who can say? Maybe oil will trend higher. Perhaps much higher, especially if we see a major supply disruption.

But high prices always sow the seeds of their own collapse. Consumers will start to conserve. Producers will search for oil that was once too costly to extract. Supply and demand will come back into balance.

Right now the bulls are having their way. But it would be foolish to believe there are no red flags on the horizon. Chief among these is that you keep hearing "the story."

You know the stories. "The internet changes everything." "They're not making any more real estate." "Oil has nowhere to go but up."

We'll see.

Good Investing,

Alex

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Today's IU Crib Sheet

Sky-high oil isn’t the only crisis grabbing the headlines. The worldwide food shortage is getting more attention by the day…

This week:

The U.S Department of Agriculture predicted grocery costs would rise another 4.5% to $2,013 this year.
The UN food program requested an additional $755-million to fill their shortfall.
Nepal banned exports of rice, wheat and other foodstuffs in an attempt to reduce the rampant grocery costs like last week’s 35% price increase for rice.

There are more than 854 million starving people worldwide. And prices indicate things won’t be getting better any time soon.

From March of last year, the price of corn has risen by 31%, rice 74%, soy 87% and wheat 130%.

The good news? There’s an easy way to invest in commodities now, without the hassle of opening a futures account.

If you are looking to take advantage of the increase in the cost of agriculture commodities check out the PowerShares DB Agriculture Fund (DBA). It’s an index ETF that tracks the liquid commodity index optimum yield return, which reflects the agricultural sector and the commodities of corn, wheat, soybeans and sugar.

DBA is up more than 40% in the last year. The S&P, of course, is in the red.