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Markets & Stocks

Bubble in crude?
A minority of analysts say oil is way too high and prices could tumble -- but will they?
September 28, 2004: 12:37 PM EDT
by Mark Gongloff, CNN/Money senior writer

NEW YORK (CNN/Money) - With oil near $50 a barrel, a handful of analysts think the energy market looks awfully bubbly and that prices could come down -- quickly.

Light crude oil for November delivery fetched about $50 on the New York Mercantile Exchange Tuesday morning, hitting another record high and a breaking through a key psychological barrier.

There's talk in financial markets that prices could break $60.

Prices have already jumped nearly 60 percent in the past year, and many analysts see good reason for it, including a surge in demand in China and other fast-growing economies, along with tight supplies under constant threat of terror attacks.

"Massive inventory declines in crude oil are part of a three-month trend, heating oil prices continue their relentless rise, and the supply disruption premium is in full effect," Wachovia Securities economist Jason Schenker wrote this week in a note to clients. "This may only be the beginning; the winter oil bull run has begun."

A small number of market watchers, however, think most of oil's gains -- if not all -- has been unjustified.

"A sudden and violent crash in crude oil prices cannot be dismissed," senior economist Thorsten Fischer wrote in a note this week. Fischer said Saudi Arabia's promise Tuesday to raise its production capacity by a half-million barrels per day proved there was plenty of spare capacity in the world.

Another oil-price bear, Bear Stearns analyst Frederick Leuffer, agrees, and has long predicted that the average price of oil in 2005 will be about $25. Earlier this year, that was a consensus forecast. Now it's in the distinct minority.

In a note last month, Leuffer estimated that Saudi Arabia and the rest of the Organization of the Petroleum Exporting Countries (OPEC), which accounts for about 40 percent of the world's oil output, generated some 2.7 million barrels a day above demand, and that the cartel had another 2.1 million barrels of excess production capacity daily.

What's more, non-OPEC supply is higher than ever, and Leuffer thinks oil companies are having an easier time getting oil out of the ground than is widely believed.

Leuffer also said that terror attacks and sabotage probably won't cause much disruption to the world's oil supply; they haven't in the past.

The bear case for oil also hinges in part on the belief that the market has been infiltrated by hedge funds and other speculators looking to ride a hot market. In this way, the bears argue, the oil market has begun to look an awful lot like the bubbly tech-stock market of the late 1990s.

Not so sanguine

But most analysts disagree, and Merrill Lynch chief energy strategist Michael Rothman noted this week that hedge funds have actually been reducing their exposure to the oil market since the spring.

Oil bulls agree there is a hefty "fear premium" built into oil, keeping the price perhaps $10 above where supply and demand would indicate.

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But they don't believe the market can simply afford to remove that premium. Terror attacks and sabotage could cause significant disruption, depending on where they take place, and traders have to get some insurance for that possibility.

"In a perfect world, you'd take the premium out, and you're looking at an oil price in the lower- to mid-30s," said Bruce Lanni, an analyst with A.G. Edwards & Sons. "But it is not a perfect world."

Most analysts aren't as certain as Leuffer about OPEC's ability to pump much more oil, or the ease of finding new oil supplies. Nor do they believe that world inventories are high enough to keep up with skyrocketing demand, particularly in China, India and other fast-growing markets.

"If you take a look at the supply-demand fundamentals in the world, there's not a lot of excess supply available or much coming on line," said Jacques Rousseau, an analyst with Friedman Billings Ramsey.

Organization of Petroleum Exporting Countries (OPEC)
Oil and Gas
Acts of terror

Oil prices, adjusted for inflation, aren't as high as they were in the late 1970s or early '80s, after the Iranian revolution and subsequent Iran-Iraq war, when they rose to the equivalent of $80 in today's dollars. Partly for that reason, most economists doubt a global recession will result from oil's recent spike.

But this is a mixed blessing -- the limited damage being done to the world's biggest economies means demand is not suffering much, OPEC said recently -- which in turn means that higher oil prices have some support.

Meanwhile, after ratcheting up their capacity to suck more oil out of the ground in the 1970s and '80s, oil companies haven't been accelerating their capacity growth in recent years, according to George Gaspar, an analyst at Robert W. Baird & Co.

"I don't think the industry has the capacity to expand much beyond the rate at which it's expanding now," Gaspar said. "When you match a relatively constrained capacity to expand against the increasing growth rate of demand for crude oil, it sets the potential course for oil to ultimately go beyond $50 a barrel."  Top of page

-- This story is an update of one that originally ran Aug. 19, 2004.

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