Bubble, Bubble, Oil Is Trouble …

Tuesday, 10 Jun 2008 | 4:11 AM ET

Is the world running out of oil? Or gold, or rice, or wheat, or almost any other commodity you care to name? Despite some usual shortages that have been offset by a surplus in other areas, there has been no significant change in the fundamentals of supply of most commodities.

Nor has there been a dramatic unexpected increase in demand from China, or India, or elsewhere for products in the commodity markets. The most likely culprit for the persistent and strong growth trend in commodities – speculators.

“Since the price hit $105, everything above $105 is speculation. Something like 50 – 100 billion dollars has poured into the market the last 2 months”, says Dr. Fereidun Fesharaki, CEO of FACTS Global Energy Group.

The disconnect between oil prices and fundamentals is a disturbing bubble. In Asia we have bubble tea. In the oil market we have bubble swaps.

In analysing oil markets, we first look at current price activity to project potential target levels relevant to the existing trend behaviour. We also look at potential pullback levels in the current parabolic trend, and signs for when the trend changes.

The most important feature on the weekly oil chart, is the development of a parabolic trend. The trend is defined by a specific type of exponential acceleration in the market. The two most important features of this trend – a known calculated date for the end of the trend and, the way the trend collapses.

As the parabolic curve moves towards vertical, it sets the maximum date for the end of the trend. The trend may end earlier, but it has a low probability of continuing beyond the calculated date. As the price continues to rise, it also moves to the right of the chart as each new price candle is added. A move to the right of the parabolic trend line is an exit signal.

When parabolic bubbles collapse, it’s a rapid drop that takes out support levels. The upside targets, and the downside targets, are established by applying the standard trend and trading analysis to the oil market. And this is a classic bubble situation.

Despite the headlines, oil moves in a tightly defined range bound pattern. Breakouts behave consistently. The breakout from $113 had an upside target of $126. The move above this has a projected target of $140. Using the same trading band projection methods, the next upside target is $152. This trading behavior can lift oil prices to an upper resistance level near $163.

So, what is creating this disconnection between fundamentals and pricing? The commodity futures market is an efficient mechanism that allows buyers and sellers to lock in prices for forward delivery. Professional futures market speculators take the risk by actively trading futures contracts. Their activity is the liquidity that oils the wheels of price discovery, risk management, and effective accurate pricing. There will always be short periods where price runs away from fundamentals due to political upheaval, hurricanes, or drought. But these excesses soon return to the underlying trend.

The difference in today’s market behavior may be due to the changing nature of open interest in many commodity markets. Open interest is a measure of the number of trades that have been opened, but not yet closed. Once open interest was short term, and largely the preserve of traders who were actively buying and selling. These traditional speculators provided futures liquidity for buying and selling.

A recent submission to a U.S. Congressional subcommittee by Michael Masters, a portfolio manager for Master Capital Management LLC, suggests this is changing. Pension funds and other long term institutional investors have been attracted to the commodity markets. These markets have become attractive high yielding investments. Institutional investors do not want to buy and sell in the short term, so they roll their positions with calendar spreads. They never sell. The average time holding period for open interest in commodity markets has been growing.

These investors provide capital, but they consume market liquidity because their positions reduce the number of contracts available for trading. This is demand for financial contacts, not the physical product. Futures pricing is the benchmark for physical pricing. This demand creates an artificial shortage in the instruments essential for the efficient operation of the futures markets. Their activity has zero benefit for the mechanism of futures markets.

Commodity investment distorts the market by removing liquidity and making it more difficult for genuine speculative risk management to proceed. Capital allocation is not related to fundamental supply/demand market factors. It’s related to the financial opportunity inherent in the market. The net effect is to make prices higher than they ought to be.

The technical analysis of the oil chart shows strong trend behavior. It also highlights the potential for a bubble and a subsequent bubble collapse. Analysis of the duration of open interest by fund managers ‘investing’ in the commodity market suggests this is the gas inflating the bubble.

The commodity bubble will likely burst when the CFTC (Commodity Futures trading Commission) closes the "swaps loophole” – which grants the banks an exemption from speculative position limits when banks hedge over the counter swap transactions.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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