Commodities: Short Term Bubble

In January 2007 oil was $60 a barrel and this morning it is approximately $137 a barrel. It is a mind boggling rise in prices that has hurt consumers and attracted significant media attention.

Speculators are widely blamed for this rise. See the attached graph by JPMorgan which shows the marked increase in speculators participation. Speculators are partially to blame for this run up but there are sound fundamental reasons for this rise. There is more demand for oil (think emerging countries like China) and a tight supply. The third impetuous is rising political risks in the Middle East. It is very likely the U.S. and/or Israel will bomb Iran before Pres. Bush leaves office. This will destabilize the supply of oil causing the price to escalate further.

Goldman Sachs sees crude rising to $141 a barrel and possibly $200 a barrel in 2009. As with all bubbles it is hard to see where and when we will reach the top and how far and swiftly we will fall when it bursts. The bubble will burst as demand begins to wane (as growth in China continues to slow and demand in the developed country contineus to drop) and supplies stabilize. Speculators will leave the market like rats off a sinking ship. This might not happen for at least a year but it will happen. I do think long term that a 3% allocation to commodity futures is a good diversifying investment if you are using futures and the DJ AIG Commodity Index. The road will be pretty bumpy and beware of any erosion in the oil futures market.