The bright side to high oil prices

Bubble or not, oil prices have room to run higher

Oil is hogging the headlines again this morning, which is convenient.

At near-$140 a barrel, the oil price is a good scapegoat for all our economic ills. No wonder Gordon Brown hopped on a plane to Jeddah to attend yesterday's meeting. Not only did it get him away from an increasingly hostile electorate, but it also drew attention away from his own shoddy economic policies and the mess they've left us in.

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The upshot of the meeting was that Saudi Arabia confirmed it will raise oil production to a 30-year high. But no one thinks it'll make a difference right away.

There's plenty of debate over why the oil price is moving higher. I suspect that it's run ahead of itself somewhat for the time being, though that's not to say it can't go any higher I'll get onto that in a minute.

But in the meantime, we should look on the bright side, even as we wince at the petrol pump. Because if the current oil price is indeed a bubble, it's a good bubble

What do I mean by a good bubble? There's an interesting little piece by Sumit Paul-Choudhury in this week's New Scientist. He talks about American journalist Daniel Gross's 2007 book, Pop! Why Bubbles are Great for the Economy. In the book, Gross argues that bubbles aren't necessarily a bad thing. They leave financial carnage, but they create the infrastructure of the future. For example, the internet boom and bust left us with a global fibre-optic network that would never have been built without the irrational exuberance of the dot.com era.

Paul-Choudhury quotes physicist-turned-risk specialist Didier Sornette's argument that "it is only during the reckless abandon of bubbles that individuals and companies take the foolhardy risks needed to develop technologies with large social impacts but low financial returns."

In other words, it takes ridiculously high prices to persuade individuals to take the ridiculously large risks needed to make big changes in the way we do things.

So if, as various Opec members claim, the current surge in the oil price is at least partly down to speculation, then what particular benefits is this bubble bringing us?

Quite a few, as it happens. Assuming we aren't actually running out, and the Saudis aren't bluffing about their reserves, then a massive run-up in prices like this acts as a dry-run for a real emergency. If oil really ran out, and we didn't have a replacement, we would be in such deep trouble it doesn't bear thinking about (though if you want to scare yourself, a quick Google search on the words Peak Oil' will bring you up a host of websites with plenty to say on just how bad the end of the oil age could be). So a bit of panic now, while we are still pumping the stuff out of the ground to a comfortable level, is exactly what we need.

At $140 a barrel, there's as much incentive as anyone needs to find new sources of oil (such as the tar sands, and even oil shale), and more importantly, substitutes. At $10 a barrel, no one's going to take the time and trouble to find a way to make an electric car viable. At over $100 a barrel, it's a Nobel prize winner.

There's also more incentive for us to become more efficient consumers. In the developed nations, that means taking public transport and maybe walking or cycling more often. That's one thing. But in many developing nations, where fuel prices are heavily subsidised, higher oil prices make it more and more painful for those governments to maintain these bonuses. Already, China and others are having to allow petrol prices to rise. That's going to be painful, but in the long run it does two things.

It makes consumers in emerging markets more fuel-efficient; and it teaches their governments the folly of price controls.

All of this a focus on new discoveries, the hunt for substitutes, increased efficiency on the behalf of consumers and governments will eventually mean lower energy prices.

So if the oil price has run ahead of itself, effectively because investors and producers and consumers are all pricing it for a future shortage, then that's a good thing. Because better to have to do all of this now, while we've still got petrol in our pumps, than have to do it once we've run out.

But when will the oil price come down? That's a difficult question. I'm a believer in the argument that we've run out of cheap oil (certainly for now). The fact that there's large and ongoing demand from emerging markets is also tough to argue with. So when I say that the price has run ahead of itself, I don't mean we're going to see $40 a barrel again any time soon.

However, we've known all this for ages after all, we've written about it in MoneyWeek often enough. Nothing new has happened in the past 12 months in terms of supply and demand that could justify a 100% increase in the oil price. In fact, the global economic outlook has deteriorated sharply which should mean that oil demand or at least demand growth, will fall if anything.

But of course, the flipside of this argument is that if the oil price isn't now driven by the fundamentals, then there's no telling when the price will start to slip back. After all, it was obvious from at least four years ago that the housing market had lost sight of the fundamentals.

So how can you tell when the tide has turned? It's not easy, but from my experience the most obvious sign of a turning point would be when everyone finally agrees that the oil price can only go higher. That's when the big correction will hit.

Just before the credit bubble popped last year with the collapse of the Bear Stearns hedge funds, the mood in the newspapers changed. There was talk of how even if credit terms were tightened, a wall of money' was waiting to come crashing in from the Middle East and Asia in the form of sovereign wealth funds. Even the most cautious commentators seemed to have thrown in the towel. Markets would stay high forever, the money would keep flowing nothing had stopped it so far, so it seemed unstoppable.

Of course, then it stopped.

When it comes to oil, the mood is turning. City analysts' forecasts are now ahead of the current price, rather than behind it. But there are still plenty of sceptical voices out there. That suggests to me that the oil price and our petrol bills - still have plenty of room to run.

But cheer up. It just gives us all the more incentive to track down a substitute

Turning to the wider markets

UK shares had another poor day on Friday, with the FTSE 100 index retreating another 88 points in a 1.5% plunge to 5,621, the lowest level since the mid-March Bear Stearns bailout. Amongst the worst casualties was department store Debenhams which hit a record low after dropping 9%. Banks also suffered, with Bradford & Bingley sliding 5%, though HBOS managed to stay above its rights price. Carphone Warehouse lost over 5% on director selling, while Wolseley dropped a similar amount on fears the company may need a rights issue.

European markets fared even worse than the UK, with the German Xetra Dax losing 2.1% to 6,578 and the French CAC 40 shedding 1.8% to 4,509.

US stocks had a grim end of week, with the Dow Jones Industrial Average plummeting to a three-month low, below the well-watched 12,000 level, to close 1.8% down at 11,842. The wider S&P 500 lost 1.9% to 1,318, while the tech-heavy Nasdaq Composite fell 2.3% to 2,406.

Overnight the Japanese market eased again, as the Nikkei 225 slipped 85 points in a 0.6% drop to 13,857. But in Hong Kong, the Hang Seng put on 77 points to 22,822.

Brent spot was trading this morning at $136, while spot gold was at $904. Silver was trading at $17.37 and Platinum was at $2068.

In the forex markets this morning, sterling was trading against the US dollar at 1.9654 and against the euro at 1.2666. The dollar was trading at 0.6445 against the euro and 107.56 against the Japanese yen.

And this morning, another house price index the Rightmove survey of asking prices shows that asking prices are now almost flat year-on-year. The average asking price fell 1.2% in May (to £239,564), giving annual growth of just 0.1%. There are now apparently 15 properties available for every one buyer, double the ratio last year. The Rightmove index is always among the more upbeat (it doesn't take account of price cuts following initial listing) but the fact that even this inherently optimistic index is plummeting shows just how bad things are.