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Double trouble

Double trouble

John Kemp, Reuters market analyst, believes that bubbling oil prices could herald the start of a second downturn. In this analysis he asks: Are we facing the dreaded double dip?

February 24, 2011 2:52 by



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 switch-backs 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. (By John Kemp. Editing by James Jukwey)

John Kemp is a markets analyst with Reuters.



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