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Blowing bubbles

Created:
10 June 2008
Written by:
Mr Bearbull

Somewhere there are clever people who have written doctorates on the behaviour of bubbles - on the ratio of their volume to the tensile strength of their surface, that sort of thing, As a result, they may have gained a lifetime's employment in the research laboratories of, say, Procter & Gamble, seeking out a better bubble for Fairy liquid. Me, the bubbles I would study are the financial ones. In particular, I would marvel at the human propensity to create price bubbles, despite overwhelming evidence that the process invariably comes to grief.

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Yet this propensity seems to be a constant in the affairs of men. Take this year. First, the bursting of the bubble in house prices throughout much of the developed world reminded us that these things almost never deflate gently. Never mind that, within weeks, the price of oil, which hasn’t exactly been deflated for many months, surged into bubble mode.

This continual process of inflate and burst in the price of financial assets of one sort or another compels me to table Bearbull’s law of bubbles. In fact, there are four laws, which blend into one and point to the disillusion and loss that are as intrinsically a part of a bubble’s demise as irrationality and hope are a part of its creation.

• Law 1: At the peak of any bubble, there are always good reasons why the price of an asset should go higher. That leads to Law 2, which states:

• Law 2: In a bubble, silly prices never look silly. Closely linked to this is the notion that the price of an asset can stay at silly levels for far longer than any rational argument would permit, and which feeds to law three:

• Law 3: Silly prices can always get sillier, until

• Law 4: When the price of any asset becomes a national - or global - obsession, it is due for a fall.

Any discussion of the law of bubbles and the oil price has to focus on the theory of peak oil. This is the intellectually respectable backdrop to the financial market's stampede, which, as its name implies, says that the maximum rate of global oil production is peaking. It may have happened, or we may be on the verge of it. The optimistic assessments say the peak is still 20 years away. Whichever, peak oil is a walking-talking application of Law 1. It underpins the $140 price and very sensible it is, too. Really, I mean that. Given that the most recent discovery of a major oil field was the Cantarell field in Mexico and that was all of 32 years ago, it is easy to see why peak oil is feasible.

In addition, we might ask, peak production in relation to what? Obviously not just global demand for oil today, which runs at around 85m barrels per day. More importantly, production must cater for future demand, which, for example, may hit 118m barrels by 2030, according to the International Energy Agency (IEA).

And while, on the one hand, production has increased - it was just 75m barrels in 2000 - the pace of increase is slowing. This, too, is not surprising given the advancing age of the world’s major fields - the IEA says that nine of the 21 largest fields are in decline. Like people, as oil wells get old they become feeble. The natural pressure that forces oil from a well during a field’s young days dissipates. As a result, engineers spend much time injecting water into the space beneath the oil and gas to force it through the well. So, fields in the US, for example, produce seven barrels of water for every barrel of crude oil. And, in the words of Matthew Simmons, an oil expert whose book, Twilight in the Desert , gave a major boost to peak-oil theory: "more often than not, a reservoir eventually drowns in the very water that was once its key pressure support and drive".

The desert to which Mr Simmons' book refers is that of Saudi Arabia, the world's biggest oil producer, about whose reserves little is known. Yet Saudi reserves are crucial. The credibility of peak-oil theory largely rests on the inability of Saudi Arabia to pump the oil that could have kept prices at, say, $60 a barrel.

Still, persuasive as it is, peak oil is just a theory and everyone knows that, if the world was to say "damn the environmental consequences", there is enough oil locked up in tar sands and oil shale to satisfy demand till kingdom come.

It may not come to that. After all, short-term demand for oil in the US is dropping rapidly. In the medium term, all those exploration projects being undertaken by hundreds of small oil explorers must have some impact. And it won’t necessarily take much to shift prices decisively. If it becomes clear that the world can pump just enough oil to meet demand without eating into buffer stocks, the price may soon collapse. In the short term, that might not even require any uplift in production. In the medium term, say to 2030, on current projections it would require a production increase of about 1.4 per cent a year.

Put like that it doesn't sound too demanding. Sure, the financial markets can't see it now. But they are obsessed with oil shortages. Yet the law of bubbles makes clear what becomes of obsessions.

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