London, 24 February 2011

Oil prices have entered unsustainable territory. Recent price surges provide strong indications of a bubble in an advanced stage. Brent prices vaulting over $117 per barrel in the last 12 hours imply the need for a global slowdown or outright recession to bring consumption back in line with diminished expectations of supply, as rising turmoil in the Middle East causes the market to start pricing in serious output disruptions.

If sustained for more than a few weeks, current oil prices will push weaker economies such as the United Kingdom back into recession and cause sharp slowdowns in the United States and oil-importing emerging markets such as China.

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No one actually believes a recession-induced reduction in demand is needed at this point. OPEC has over 4 million barrels per day of surplus capacity, more than 2.5 million bpd even if Libyan production was lost entirely. Commercial inventories of both crude and refined products are ample, more than enough to cover a temporary loss of output. OECD countries hold commercial crude and product stocks amounting to 2.7 billion barrels of oil. In addition, OECD countries hold 1.5 billion barrels of government-controlled strategic stocks that could be released in an emergency, according to the International Energy Agency (IEA).

Combined commercial and strategic stocks amount to 91 days consumption. They could cover the total loss of Libyan exports for 8.9 years and the complete loss of exports from all OPEC members for almost 5 months. China and other developing economies have been building their own reserves to insulate themselves from physical shortages or severe price movements. While the extent of non-OECD strategic stocks is not reported, total global inventories are very high, and there is no physical threat to the adequacy of global oil supplies.

In a narrow sense, it is true to say "the market cannot accommodate another disruption ... with the problems in Libya potentially absorbing half of OPEC's spare capacity," as analysts at Goldman Sachs observed in a research note. It is easy to construct doomsday scenarios justifying almost any price level. Prominent analysts have recently been busy publishing some extreme projections at $150 or even $220.

But it is harder to assign a probability to such scenarios. The market is pricing as if such doomsday scenarios were a virtual certainty rather than merely an outlying possibility. Investors risk becoming fixated on tail risks while neglecting the central part of the probability distribution.

Futures markets are pricing for the virtual certainty of substantial supply disruptions in the next few months and starting to force a brutal recessionary reduction in demand to meet them. This is an extreme over-reaction which has no foundation in fundamentals. Nothing has changed in the past 24 or 48 hours that can come close to explaining a $10 increase in the price of Brent crude (more than $5 overnight).

The accelerating increase in prices has all the hallmarks of the advanced stages of a bubble. The relentless rise in prices and network effects among traders and other market participants have encouraged everyone to try to get long on the price and caused the virtual disappearance of short sellers. It is what economists would term a bubble and physicists would call a "self-organising criticality."

Such phenomena are inherently unstable. Price increases must keep accelerating to give all traders the expectation of increasing returns to offset the rising risk of a setback. No one can predict the point at which a bubble or criticality will break down -- either the timing or the price level. The point of breakdown is inherently probabilistic or stochastic, which is what allows a bubble to occur in the first place. But the exceptional volatility in prices observed in recent days, and the exponential rise in prices over the last three or four months, are both characteristic of the advanced stage of a market caught up in a bubble. They are also both reminiscent of the sharp price movements and then switchbacks which erupted in the oil market as prices peaked between April and July 2008 and began to subside in August.

Soaring prices are also inherently unstable because they will quickly start to push the major economies back towards a double dip, making deep cuts in demand and restoring much of the cushion of spare capacity investors fear (but do not know) will be eroded.

The impact of a renewed downturn would be far worse than in 2008. OPEC members led by Saudi Arabia are already carrying substantial excess capacity. Unless Libyan output was lost for an extended period, Saudi Arabia would have to throttle back production even further to rebalance the market and avert steep price falls.

Both monetary and fiscal authorities have far fewer degrees of freedom to respond to a renewed downturn than they had in 2008. Interest rates are already close to zero across most of the advanced economies and governments are under pressure to cut both deficits and debt levels.

Widespread unemployment in North America and Western Europe and continued pressure on household finances have left consumers ill-prepared to absorb a hike in energy prices.

For all these reasons, the current level and trajectory is unsustainable beyond the very short term.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.