There are perhaps, two hallmarks of an asset price bubble. Both happen after the fact, or as the bubble is bursting. Actually, one could easily argue that bubbles only ever materialize after they burst; only then is the bubble that inflated under everyone’s eyes transformed into something other than a really “good bull run.”

Back to the hallmarks. The first is that the majority must agree it was a bubble. The second is public outrage and regulatory actions that arise as unsound business practices built on flimsy assumptions begin to unravel (think, for instance, of the collapse of Bernie Madoff’s ponzi scheme in the aftermath of the 2008 financial crisis).

Neither of those has materialized just yet when it comes to the energy sector, but it feels like they are getting closer.

To wit, the subtle change in the narrative regarding oil prices – not from how much further they will fall but to why did they get so darn high in the first place?

Two thoughts spring to mind.

The first is the below chart, showing a proxy for financial system liquidity against U.S. oil production (it is stolen from DoubleLine’s Jeffrey Gundlach and comes via Driehaus Capital).  At a time of excess money sloshing around the financial system, investors (aided by banks keen to boost their profit margins) poured into the commodities sector in the hopes that enough latent demand would eventually materialise to justify their spending. Ready capital has enabled a boom in shale production, helping to tip the supply balance far out of whack with existing demand and adding to an already-existing glut in stored supply. This was arguably the smart money, by which I mean big professional accounts.

Then there is the dumb money, a.k.a retail investors. They have been told a similar narrative about continuous emerging markets-fuelled, inflation-related growth in demand for crude (peak oil anyone?) combined with a foundational belief that oil markets tend towards backwardation (where, in fact, from 2008 or so they have been in persistent contango). Even before 2008, however, oil investment was an easy loser. Reuters columnist John Kemp noted in 2012 that: “Returns on the [Goldman Sachs Commodities Index] and its derivatives have been lower than U.S. equities over almost any time horizon since 2000. That underperformance was probably masked by surging oil prices, but becomes ever more apparent to investors as the spot price plateaus.

I doubt these are the only reasons for oil’s stunning run and subsequent collapse (and there’s a reason this post is categorised as a random thought) but they certainly seem to have exacerbated it.

Oil at $200 a barrel – Goldman’s famous 2008 call – turned out to be dream. One wonders if oil at $100, or $90, or $75, or $60 – proves to be but a bubble.

Some selected reading on the topic below.
BIS: There’s an oil-debt-dealer nexus – Tracy Alloway, FT Alphaville
Crude slide sparks oil-related debt fears – Tracy Alloway, Financial Times
Financialisation compounds commodity rout – Satyajit Das, Financial Times
Citi: Capital markets now control oil prices – Tracy Alloway, Bloomberg
How the dumb money was set up for commodity failure – Izabella Kaminska, FT Alphaville
Tales of Saudi exports and commodity investing – Emad Mostaque, Ecstrat
Deconstructing oil – Emad Mostaque, Ecstrat
Are commodities at risk of de-financialization? – John Kemp, Reuters