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Sunday, November 16, 2008

the BUBBLE that wasn't

Flash back to April or May of this year and consensus at least among the people I interact was convinced of a 'bubble' in commodities and especially Oil. Even amidst signs of a slowdown in global growth, Oil was scaling new heights coming close to US$150/bbl. It was argued that the rise in Oil amidst signs of slowdown in global growth was proof enough of Oil market being manipulated by hedge funds and speculators in general.

I have never been a taker of bubble in Oil market. Firstly, for technical reasons; One must differentiate between something being overvalued and something being a bubble. While in both cases, prices are significantly above what fundamentals justify but the key difference between the two lies in degree. Every bubble leads from over valuation but not every valuation is a case of a bubble. We should not use the term bubble lightly. Over valuation (as is under valuation) is very frequent in financial markets but bubbles are not so frequent. Two examples. Property bubble in Japan – after it collapsed, land prices fell year over year basis for 15 years in a row from 1991 to 2005. Six years after the dot com bubble collapsed, Nasdaq at its peak (of last year) was still one-half away from its peak during dotcom bubble.

However now that price of Oil has fallen 60% from its peak, I still do not believe that Oil reflected a bubble, largely because most assets have fallen significantly. Equities across the board are down over 50%; even some currencies are down 40-50%. Indeed as events have turned out, it was not Oil that was a bubble but the entire edifice on which the ‘modern’ finance was built was a bubble. It has burst, world economy is on the brink of a global recession so its only reasonable that equities and commodities alike fall.

However, being a believer in the concept of falsifiability, I my belief that Oil was not a bubble has to be falsifiable. I will concede that Oil was a bubble if as economic growth decelerates, Oil slides down to its previous cycle lows (it bottomed ~US$10/bbl) of late 1990s and when the recovery happens Oil as will other commodities will rise but they do not go anywhere close to the highs witnessed this year. In a way if Oil (and this is true for most other commodities) resumes its ‘normal’ cyclical behavior in the next cycle (range of say US$10-US$50), I would concede that Oil was a bubble…

Let’s wait and watch…