Oil: Anatomy of a Bubble

The word bubble, when applied to an economy or economic sector, evokes fear and loathing among financial professionals around the world.

The bursting of the U.S. housing bubble in 2008 in particular left people on almost all income levels feeling battered and scarred. But this sentiment may also have created an exaggerated and irrational dread of bubbles call it bubblephobia.

Bubbles are natural market phenomena. As markets allocate capital to various users, reason is inevitably overtaken by emotional factors.

Careful analysis is brushed aside by greed. And as markets become increasingly overheated, herd mentality and groupthink force capitulation, opening the floodgates wide in the capital allocation process.

And then the bubble bursts!

The bubble du jour is oil. The oil bubble burst this summer. A couple of months later, oil prices started to crash. Investor capitulation to supply-tilted price momentum is now provoking across-the-board selling and accelerating the slide.

The ripple effects of oil as a socio-economic meteor are now being felt throughout the global economy.

The oil bubble was triggered by two broad interrelated factors. One factor was change in oils supply/demand equation. The second was the adoption of oil as a store of financial value.

Many factors contributed to an oversupply of oil. With oil trading at over $100 per barrel, global exploration hit a fever pitch around the world. New technologies, hydraulic fracturing in particular, enabled energy companies to bring vast untapped reserves into production. And certain countries, including Iraq, increased production following years of political upheaval.

At the same time, a modest slowdown in certain emerging economies, China in particular, softened demand. Globally, conservation driven by environmental concerns and the high price of gasoline further dampened overall consumption.

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Oil: Anatomy of a Bubble