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Analysts warn of oil price bubble

The flood of speculative investment into oil markets is inflating a price bubble that could pop and send crude prices sharply lower if US petroleum demand continues to slump, analysts warned yesterday.

Crude prices continued their remarkable rally yesterday, rising 95 cents (US) to close at another record high of $105.47 on the New York Mercantile Exchange. But the boom could be setting the stage for its own undoing, many analysts argue, since it is being fuelled by speculators looking to hedge against a declining US dollar and devalued financial assets.

Some analysts are forecasting a sharp correction in the price of crude this spring. “It’s hard to argue that prices should be higher [now] than they were not too long ago,” said Michael Lynch, president of Strategic Energy and Economic Research Inc., of Cambridge, Mass., who has forecast that crude markets are set for a massive correction that could eventually bring prices as low as $50 a barrel. “I think this is definitely a bubble because it is financial investors who are putting money into the market, not oil traders.” But others argue that oil prices are heavily influenced by non-market factors, and those factors could extend the crude rally. Unlike other recent bubbles – involving mortgage-backed securities or dot-com stocks, for example – the oil market is often driven by geopolitical concerns, from turmoil in the Middle East to the threat of a war involving Venezuela, by weather-related shocks and by the manipulations of a powerful production cartel that is determined to defend high prices.

Oil has been on a tear since last summer, when investors began reacting to financial turmoil and economic weakness in the United States – and the resulting decline in American dollar and interest rates – by moving aggressively into crude oil futures markets. Since then, crude prices have climbed nearly 50% from $70 a barrel. That increase came even as analysts were reducing their forecasts of global demand growth this year, in light of growing economic weakness in the United States and elsewhere. The stunning price rise has been driven almost exclusively by investors who were bailing out of the dollar and other financial assets and pouring into commodities, Judith Dwarkin, chief economist at Calgary-based Ross Smith Energy Group, said yesterday. “The fundamentals don’t support prices at $80, let alone $100,” Dwarkin said. She said global demand growth has slowed in recent years, while spare capacity among members of the OPEC has expanded somewhat, even as inventories of gasoline are at robust levels. “The greater prices diverge from what is fundamentally supportable, and the longer they stay at a distance from what is fundamentally supportable, the greater the risk of a correction, and a large one.” She has forecast an average price of $75 a barrel for this year.

Oil consumption in the developed world is dropping more sharply than anticipated just a few months ago because the subprime crisis has contributed to increasing economic weakness, Lynch said. Even emerging economies have slowed their demand growth in the face of record high prices, he added. Prices are remaining high owing to speculation. “It’s people saying the stock market doesn’t look good, real estate doesn’t look good, the dollar doesn’t look good, so let’s buy commodities,” he said. He said prices could drop below $50 a barrel over the next three to five years, if OPEC is unable to significantly cut production in the face of weaker demand.

But Adam Sieminski, an energy economist at Deutsche Bank AG in New York, said he is becoming increasingly skeptical of his firm’s official forecast that oil will fall to $80 in the spring. “Every one who has tried to bet against this market to the down side – unless they are very nimble – has lost money,” he said. The Deutsche Bank analyst said the slowdown in demand is not severe enough to puncture the buoyant mood. At the same time, there is little spare production capacity of light sweet crude and virtually no additional refining capacity. “The markets are horribly vulnerable to anything that goes wrong, anywhere in the system,” he said. Should the market weaken, he added, OPEC members appear determined to cut production to defend the price at a much higher level than was previously the case. “OPEC is getting used to higher incomes and would be more willing to defend a much higher price than what we would have thought before,” he said. (Globe and Mail, Canada)