The Black Bubble, Scott Kramer
Monday August 22, 3:30 pm ET
Controversial Texas oil analyst Matt Simmons recently announced that oil could very well reach $100 a barrel. He is quoted as saying, “We could be at $100 by this winter. We have the biggest risk we have ever had of demand exceeding supply. We are now just about to face up to the biggest crisis we have ever had.” When looking for a bubble always watch out for superlatives such as “ever.” But before scenes from “Mad Max” start permeating your every waking thought, and before you run out to the garage to make sure grandpa's shotgun is still there, take a deep breath.
“In crowds it is stupidity and not mother-wit that is accumulated.”
Gustave Le Bon
Wow! As traders, comments like this instinctively create an excitingly romantic mental imagine of us clicking a button to purchase crude oil call options, only to watch them take off l! ike a rocket with the next stop being early retirement. We flash forward 5 years and picture that Ferrari or Yacht. We imagine what it will be like having our grandson sit on our knee in front of a huge glowing fireplace as we spin yarn of the olden days and how we had the foresight to buy oil at $65 or $80. Boy does the greed factor kick in! But that is what a bubble is: massive greed stepping on the shoulders of greed. People building castles in the sky and not caring about the economic laws of supply and demand. One even rationalizes playing a bubble while knowing what they are doing is wrong. The thinking is something like, “I know I shouldn't buy a stock at 300 times earnings; however, I just know there is a fool out there who wants to pay 350 times earning tomorrow.”
The really amazing thing is that no one seems to learn the lessons of the previous bubble, but rather curiously appear to jump in to the current phenomena, hoping to make back the losses! incurred from the previous one. Perhaps they believe the old axioms “ lighting never strikes twice” and “this time it is real.”
One of the more notorious and memorable bubbles was the Dutch Tulip Craze that occurred in Holland during the 17th Century. It is also a less sensitive subject to discuss than the NASDAQ bubble, which burst in 2000 and continued to deflate for 2 years until the index lost about 80% of its value.
A virus termed “mosaic” infected a small portion of the tulip bulbs. Though the disease was not harmful to the tulip, it did result in the affected bulbs exhibiting bizarre flame-like colors and patterns. As this condition was rare, it resulted in collectors coveting infected bulbs, thus the limited supply and healthy demand forced prices higher with every passing day. During the last phases of the obsession (roughly 1634-1637), most of Holland became struck with Tulip-Mania.
Everyone from nobility to gardeners began to rationalize investing in the bulbs as a smart investment, and ! the continuously rising prices seemed to justify these as smart investments. Eventually things got so out of control with demand that a single bulb could command as much as $80,000 converted into today's U.S. Dollars. At the peak in January 1637 there was a twenty-fold increase in the price of bulbs.
Much like how people could rationalize taking equity out of their homes at 7% to invest in NASDAQ stocks in the late 1990s, many 17th century people in Holland sold their homes, thinking that a few bulbs would net them two homes in a few months' time. Eventually the laws of gravity took affect and what was once a market with only buyers became a market with only sellers.
Realizing the potential catastrophic affect a crash would have on an economy focused on one product, the Dutch government stepped in made a public statement declaring that there was no reason why the price of tulips should fall. Not surprisingly, government reassurances didn! 't work as hoped, so the government stepped in and guaranteed the pric e of tulip bulbs at 10% of the high price. Not long after that tulips fell through the government's floor price, which nearly bankrupted Holland's government.
Other notable bubbles beginning/end
South Sea Bubble
Panic of 1837 in US
1847 – the bursting of the UK railway bubble
Financial Crash of 1873
1927- Bubble in US high-tech stock termed Lindbergh Bubble
Black Monday – Stock market crash of 1987 (October)
1989 (mini-crash) – Sparked by the failed buy-out of UAL
January 2000 -2002 – The Mother of All Bubble – NASDAQ/DOT.COM bubble bursts sending the NASDAQ DOWN ABOUT 80%
St! ock market crash of 1929 (Examples of prices below)
RCA $505 to $2 ½
GE 396 ½ to $8 ½
Montgomery Ward 137 7/8 to $6 ½
The above is a small list of bubbles, and there are countless others I could have included. The interesting thing about bubbles is that they usually occur relatively shortly after the sting from the previous one has just worn off.
Reasons Why the Oil Bubble Can Pop
One reason why bubbles form is that many good arguments can be made for “why this time things are different.” Generally speaking, as a whole, the public is not crazy. The media sells people on the best or worst case scenarios. For the last 70+ years people have heard reports from so-called specialists about how there is only so much oil in the world, and eventually it has! to run out. Yet if you look at the predictions the specialists have m ade about when the last drop of oil will be pumped out of the ground, you notice that every couple of years the date gets extended out a few more years.
Since the first man was chased by a saber-tooth, we've devised ways to get ourselves out of a bind or be forced die. It is called Social Darwinism. About 1,000 BC, man invented the bow and arrow for this reason, and you don't see many saber-tooths in the wild anymore. Technology has always provided man with the solutions to his self-created problems. And technology will continue to do so. Better refining techniques, off-shore drilling, etc. have all been designed to overcome oil supply problems.
A more immediate solution of high oil prices will likely come voluntarily from man. When fuel prices at the pump get pricey enough, people will stop driving to work and begin to take public transportation. Families will cut back on the long drives to the countryside on weekends and opt to go to a matinée instead. Peop! le will chose to work from home more, and corporations will help provide incentives to do so. People will begin to car pool more. The federal government, which currently collects over $53 Billion a year in fuel tax may be forced to lower said tax in order to stave off a recession. People will turn in their Hummers for the modern day equivalent of the Ford Pinto.
Certainly oil can still run up a little more, making it more tempting with each advance to want to get in on all fun. That is the hook. Besides, it takes a long time for all really big fools of the “greater fool theory” to hop on the trend. Keep in mind that crude oil has risen 16% in the past three weeks alone. At $3, $3.25 or $4 a gallon, people will cut back.
All the cutting back of petroleum use will result in an increase supply of gasoline, which will have the direct result of lower prices at the pump. The laws of supply and demand may be slow; however, Alfred Marshall's mi! croeconomic laws do work well. Simply speaking, if it gets too expensi ve, people won't buy it. When no one buys a vendor's product, said vendor must reduce the price in order to get rid of the inventory. Besides, if that doesn't work, we can always start a war in the Gulf to fix the problem. In conclusion, don't get sucked in to this black bubble. The money will be made on the downside, not the upside.
Predictions? Oil will likely hit $50 a barrel before you see it at $72 (let alone $100). I am, however, waiting to see a little more greed.
Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
scott.kramer@optionetics.com
