The oil bubble bursts – for now

Up until recently, oil has been about the one market in the world that investors could rely on to go up. But now even the price of black gold is tumbling. After running up to record highs of $147 a barrel, crude has dropped sharply, slipping 15% in little over a week.

A big move like that should be no surprise oil is a volatile market at any time. But in recent months, surprises have been almost exclusively on the upside. Now investors who've watched its seemingly unstoppable surge for weeks are wondering if this is the end of the bull run. Could oil be poised for a sharp correction?

We think it probably is. As we've been saying for several months, the oil market has been looking more and more overbought. After spending five years in a steady, solid upward trend, crude exploded upwards at the start of this year (see chart).

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The Brent benchmark rose by $55 a barrel (63%) between January and June, without any significant change in the fundamental outlook. Indeed, as we'll see below, the outlook for both demand and supply is increasingly bearish for oil prices in the near term.

There's been plenty of debate over exactly how much oil prices have been affected by the amount of investment money flooding into the market. But looking at the sharp jump in prices, and the sheer volume of money involved, it seems pretty clear that speculators have had some influence, even though they don't take delivery of the physical product.

In the first half of the year, an estimated $22bn flowed into commodity funds tracking the two main commodity indices, according to Guinness Asset Management. At a price of $100/barrel, that would be equivalent to extra demand of 1.2 million barrels a day. By comparison, China the number-one argument for strong demand in commodities of all sorts looks likely to increase oil consumption by 'just' 500,000 barrels a day this year.

As we know from bubbles throughout history, speculation can push markets a long way above their fair value. And because oil and other commodities are so vital to the economy and our way of life, it takes quite some time for people to start reacting. Even though petrol prices may be spiralling upwards, drivers grit their teeth and pour ever more money into their fuel tank. But if prices rise high enough, people cut back and often very suddenly.

That's what's happening now. 'Demand destruction', as economists call it, is taking place all over the world. American drivers cut the amount of miles they drove by 3.7% in May compared with a year ago, according to the latest government figures, and gasoline consumption is falling accordingly. Petrol sales are down 20% over the past 12 months in the UK. In Asia, previously sheltered from much of the impact of costly oil by government fuel subsidies, last month's subsidy cuts are already reported to be hitting demand in countries such as Taiwan. Even China seems to be seeing a slowdown in economic growth (GDP growth slowed to 10.1% in the second quarter, down from 11.9% in 2007). No surprise then that the International Energy Agency (IEA)has cut its estimate of demand growth for this year from 2.11 million barrels a day (mbd) to 1.03mbd.

The big question is: what happens to oil now? To answer that question, you need to distinguish between the short-term which is bearish and the still-bullish long view. For investors with a very long-term goal, we remain convinced that oil is a great industry to be in. One figure alone serves to illustrate this: despite China's years of rapid growth and development, its oil consumption per capita is still less than a tenth of American demand. As emerging Asia fully industrialises, the amount of extra oil that will be needed to fuel its shift towards developed world standards of living is huge.

There will certainly be some substitution of oil in favour of other fuels and energy sources. But substitution is a slow process, most alternative energy sources also have high costs and there is as yet little alternative for most transport fuels. There's no immediate alternative to oil and with much of our future supply coming from sources that are difficult and costly to tap, high prices are inevitable. In fact, lower oil prices today help to guarantee higher ones in the future. The lower the price, the less investment there is in new production especially expensive sources and the less oil there will be to meet future demand.

So in due course, we expect oil to head much higher again. But in the short term, it's a very different story. It's entirely possible that oil could fall a long way. Demand destruction is likely to gather speed over the next few months, helped by the slowing global economy. America and many European countries are headed for recession or a prolonged period of slow growth, while developing Asia which has driven the increase in demand for the last few years will also suffer the impact of recent fuel subsidy cuts on domestic consumption. In this environment, it's hard to see how global demand can hold up at levels that might justify the $120-$130/barrel that the consensus is currently forecasting over the next year or so.

At the same time, the supply picture is looking healthier. An estimated two million barrels per day of new Opec capacity will come on stream next year, according to Edward Morse of Lehman Brothers. Meanwhile global refinery capacity is set to increase by 13mbd over the next five years, removing another bottleneck from the system.

So how low might oil go? Morse, one of the few analysts currently bearish on oil, reckons it will average around $93 a barrel in 2009 about 25% below current prices. But given that markets which have experienced a lot of speculation tend to lurch to the downside when speculators turn negative, we think it's quite possible that oil could dip lower still.

But $60-$70 a barrel looks a likely minimum for a number of reasons. As regular MoneyWeek contributor James Ferguson points out in his Model Investor newsletter, the recent surge upwards has been so far above trend that a fall back to that level wouldn't even break oil's long-term bull trend. From a fundamentals perspective, $60-$70 a barrel is also roughly the price at which unconventional oil sources, such as tar sands, many offshore deep-water fields and a number of alternative technologies such as gas-to-liquids, coal-to-liquids and some renewable energy sources, become genuinely economically attractive.

Finally, there's the political consideration. Opec members need high oil revenues to be able to balance their budgets and support the spending programmes that keep their often-dysfunctional economies and societies ticking over. What matters here is Saudi Arabia, because it's the producer that has the most scope to alter its output to manipulate the market and the oil price that balances its budget is again $60-$70/barrel, according to Muhammad-Ali Zainy of the Centre for Global Energy Studies (although with many other Opec countries having higher breakeven prices, he thinks there would be considerable pressure on Saudi Arabia to cut production if oil were to fall even as far as $90 a barrel).

So what are the consequences of a big fall in the oil price? The obvious benefit is on inflation. Not only does cheaper oil mean cheaper gasoline and other fuels, but natural gas and electricity tend to be closely related to crude, while the price of other goods that use plenty of energy and oil products should also fall.

But don't expect that to happen overnight. Oil has risen so high and so quickly that at anything above $90 a barrel it will still be contributing to year-over-year inflation until January. And since it takes time for price rises and falls to pass through the system, the lagged impact of the latest run-up could easily continue to feed into other prices for many months before falling prices bring them back down again.

Still, combining the disappearance of energy inflation with the deflationary effects of the credit crunch and we could be looking at quite a sharp fall in inflation over the next year. Indeed, the dreaded 'd-word' deflation might start popping up again, as it did after the last global slowdown in 2001-2002.

The respite may be short-lived, depending on the way central banks react. We suspect that they will try to re-inflate, to avoid the risk of deflation which they fear much more than inflation and to diminish the real value of debt burden hanging over so many Western countries. Medium-term, an inflationary world still looks the most likely outcome. But a halt to rising energy prices could well give us a couple of calm years on this front.

This is not the return of the days of cheap money for all, however. Unlike the late 1990s and early 2000s, strong growth will not accompany lower inflation. Even if central banks do cut interest rates in an effort to stimulate the economy, the hangover from the debt binge will leave economies from America to Britain, and Spain to Ireland, sluggish for some time to come. As the Japanese found out to their cost, even 0% interest rates can't help if your banks have no money to lend and consumers are too broke to borrow.

Emerging markets don't have the same debt problem to cope with. But slow growth in the developed world will be a drag on export-orientated countries until they can find new sources of strength, while many also have an inflation problem that won't necessarily go away as oil prices fall. In India, for example, there are signs that inflation pressures have spread beyond energy and food into the wider economy meaning that the Reserve Bank of India is likely to keep rates reasonably high for a while to squeeze these second-rounds effects out of the system. Less inflation is good for Asia, but don't expect a miraculous rebound in growth this year.

It will, however, be good news for Asian government budgets. Even after some recent subsidy cuts, many are groaning under the strain. Economists at DBS calculate that India's fiscal deficit would hit 10% of GDP if oil were to average $140 a barrel this year, and the debt to GDP ratio would rise from 79% to 82%. That would undo several years of improvement in the country's public finances and put its already weak credit rating under further threat.

But even if oil were to retreat to $70 a barrel or so, importers in the West and Asia would still be forking out far more for energy than a couple of years ago. There would still be a large transfer of wealth from these countries to producers in the Middle East, Latin America, Russia and Africa. Countries that have managed their oil bonanza prudently will continue to boom. However, their overheated stockmarkets may not, at least in the near term. We look at the likely impact of cheaper oil on investments below.

Short oil and get out of Latin America

The easiest way to profit from falling crude oil is through a short exchange-traded fund (ETF), such as the one offered by ETF Securities under the ticker SOIL. For every 1% that crude falls, the ETF rises by 1% conversely, if crude rises, the ETF's value falls. For more details see ETF Securities, which also provides a number of other short ETFs if you want to bet that other commodities will come off in line with crude. ETFs are the safest and easiest way to short a market, since you can't lose more than your original stake, but more experienced traders might also want to look at spreadbetting it, investing directly in futures, or using put options.

But for many investors, it's more important to think about which parts of your portfolio could be severely hit if oil comes back sharply. For example, Latin American funds will be highly sensitive to weakness in oil take a look at the chart of the MSCI Latin America index versus crude and notice how they've risen almost in sync since the oil bull market began.

That reflects the importance of natural resources in Latin America's exports, and the way that resource producers dominate their stockmarkets in Brazil, oil major Petrobras and mining giant Vale account for 30% of the index.

So we'd get out of regional funds that are heavily invested in these companies and are likely to fall sharply especially if other commodities follow oil down. As well as Latin America, that applies to Russia, whose RTS index is also very energy-heavy. But of course, with so much accumulated oil wealth still sloshing around these countries, domestic demand stocks such as consumption and construction plays could continue to do well in those countries that are reasonably well-run and have used their oil bonanza fairly prudently, such as Brazil, Russia and the Middle East.

However, others that have squandered their windfall, bleeding their national oil firms dry to plug budget holes and leaving them with too little to invest in new production, could find themselves in severe trouble once oil prices are no longer spiralling upwards. Venezuela is Latin America's leading basket case, but the problem is widespread: for example, the Mexican economy isn't especially healthy and its stockmarket is clearly expensive.

What about oil stocks?

Although the sector will probably weaken short-term as crude does, we won't be bailing out of positions in oil majors such as BP (BP), Royal Dutch Shell (RDSB) and Total (NYSE:TOT). Current valuations are cheap even at much lower oil prices and yields of 4%-5% give you an attractive, inflation-protected income stream while you keep your position in the long-term bull market.

However, BP's recent problems in Russia reinforce the point that these stocks have political risk and your portfolio should be diversified among several. We'd also hold on to oil field service stocks, especially those that work with the larger producers. Even a big fall in crude would have little impact on spending plans at the majors, since they are assuming long-term prices of $60-$80/barrel in planning new projects. So there should still be plenty of cash flowing to their contractors.

However, marginal producers will be hit for a firm ekeing out the last barrels from an end-of-life North Sea field, there's a big difference between its profits at $140/barrel and at half that. Small oil explorers are also likely to come back sharply, since these stocks attract a lot of speculative interest when oil is booming and see it dry up in quieter times.

Outside the oil sector, lower energy costs will be beneficial for most firms but that will be outweighed in most cases by the global growth slowdown. If inflation falls enough for central banks to cut rates, that could help the beleaguered financial sector, which will see its funding costs cut. But it's certainly not time to get back into financials yet especially since, given their track record so far, there has to be a good chance that many were betting big on higher commodity prices. As Roger Bootle puts it in The Daily Telegraph: "Believe me, if there's a way oflosing money lying out there somewhere, they will find it."