The Toronto Stock Exchange Composite Index, which is a de facto proxy for commodity prices if you removed RIM and the financial stocks, hit over 15,000 recently due in large part to the run up in oil prices to over $130/barrel. Several analysts have now hopped abroad the “here comes $200/barrel” train in recent weeks. The argument for higher oil prices is pretty simple: China and India are going to need more demand for oil and there isn’t a corresponding supply to feed it. While I am a supporter of the peak oil theory, the cynic in me wonders if this isn’t the third great bubble forming in the last 10 years after tech stocks and real estate.

Remember that money is very cheap and the Federal Banks keep injecting money into the system- essentially, none of the brokerage houses are playing with their money anymore. It is yours and mine they are playing with in the form of bailout money. With bank stocks having attracted the koodies, there’s nowhere to put cheap money but in oil and commodity stocks and, hence, a run-up in price but is the run-up justified?  While I do believe that energy prices will continue to go up, should it really go up this fast? I point to three different factors why oil is bubbly to me:

1. Analysts assume that consumption patterns will remain the same as prices increase and rely on the assumption that China and India will have North American consumption patterns. I take Peter Lynch-esque view to oil. On main street, we are already beginning to see the effects of high oil prices. No one in my circle of friends is buying SUV’s anymore; people are looking at diesel cars or smaller and more fuel efficient cars. Ford admitted that the SUV is a trend that’s now past. Most people I know aren’t flying to vacations this summer- it is getting too expensive with multiple fuel surcharges. The point being that we have hit a wall; our consumption patterns are changing and demand will most likely decrease. On the other side of the coin, why do analysts believe that Chinese and Indian consumers will behave exactly like North Americans? Have they left their glass towers and ever been to China or India? North Americans are huge consumers of energy (gas, oil, water etc.)- much more so than other parts of the world (including equally developed Europe). It stands to reason that it is a huge assumption to make that one North American consumer will equal one Asian consumer in terms of consumption patterns. Yet, analysts seem to believe that consumption per capita should be same when statistics indicate they do not. Yes, oil prices will continue to go up- inflation alone will be responsible for it- but it leaves out the assumption that prices will affect consumption behavior and takes an ignorant approach that everyone will consume in the same manner as North Americans.
2. The price of oil to the price the of natural gas is off its historical ratio. Historically, for every $1 of MMBTU (million British Thermal Unit which is how natural gas is quoted) of natural gas, oil should trade at $6/barrel. In other words, the ratio between the price of oil to the price of natural gas should be 6:1 all things being equal. Natural gas is being quoted at a $12.15 in New York on May 21. Assuming a barrel of oil was approximately $130/barrel that day, the ratio of oil to natural gas prices is approximately 11:1. Just as the abnormal ratio of housing prices increases to rental rate increases pointed to an eventual correction in housing prices, this ratio tends to indicate that oil has either risen too high or natural gas not risen high enough. The issue in Canada is that the easy natural gas supplies are running out in Alberta which explains why natural gas money is moving out of Alberta to British Columbia (the oil royalty regime is a convenient smoke screen to the real problem in Alberta- they are running out of natural gas deposits which are easy to tap). In other words, natural gas has the same supply concerns as oil so why is oil going up so much faster? Perhaps, we have an oil bubble? While the 6:1 ratio can be off for the short-term, just like real estate, it has to come back to historical ratios.
3. Coal- the future of energy?!? Coal gasification and liquefaction are two methods to produce gas or diesel- the biggest side effect being the production of large amounts of carbon dioxide (which supporters claim can be captured underground). The technology isn’t new (the Nazi’s used coal liquefaction when they ran out of fuel in WWII) and coal is certainly in abundance. With the price of oil being what it is, there’s been a revival of coal as a fuel source not just to burn but to produce gas and diesel; Sherritt International Corp., a commodities company with holdings in Canada and Cuba, announced it wants to build a $3 billion coal gasification plant in south-east Edmonton last week (conditional upon the Provincial and Federal government providing clarity on carbon emissions so it could cost the plant properly). Brazil (which, if you have been paying attention, is probably the next big country to watch) has used coal liquefaction for years and China has a lot of coal which it can use rather than conventional oil. The point being that a lot of smart money is already beginning to make bets on other energy sources that are not pie in the sky ideas which will alleviate demand pressures for oil.

If nothing else, I am a realist. Oil will continue to go up. But is $130/barrel a proper valuation right now? Probably not. If you connect enough dots (changing consumer behavior, cheap money with nowhere to place it but in the new “it” industry, historical ratios, where smart money is moving), it appears that oil is over-priced in the short-term. Of course, I could be completely wrong and paying $100 at the pump by the end of the summer but am I paying that because that is the true price of oil or because we are living in an oil bubble?