Show Me the Bubble!

By Chris Puplava, April 9, 2008

Enough is enough! As most commodities rallied strongly in February and into early March, many in the financial press were calling commodities a "bubble." What happened to the commodity bubble of 2005, 2006, 2007? Commodities kept climbing the wall of worry. Long gone are the days of $50/barrel oil or $1/gallon gasoline, with the trend in these commodities, and commodities in general, continuing to advance despite being heralded as a bubble.

The mistake analysts often make is interpreting the short sprints that commodities undergo as signs that they are in a bubble instead of understanding that bull markets frequently get overheated along the way to their eventual peak. These short-term periods of overextended prices are followed by quick, nasty corrections that shakeout the hot money crowd while the smart money holds fast to their convictions until the fundamentals prove otherwise.

PAST BUBBLE EXPERIENCE

Bull markets turn into bubbles when feverish speculation produces excesses that reach unsustainable levels accompanied with valuations exceeding historical norms. The two most recent bubble examples are the technology bubble of the 1990s and the housing bubble from this decade. What is interesting to note is that many in the press praised these bubbles as they developed with "this time is different" and "new era" nonsense, completely ignoring the balances between supply and demand as long as everyone enjoyed the asset inflation along the way.

One of the easiest ways to spot a bubble is in terms of excess supply. The number of technology IPOs surged as did technology employment and capacity during the 1990s. A clear warning sign that the technology bubble was about to burst was the surge in total inventories as excess investment in technology led to a saturation of the market in terms of industrial capacity. The capacity utilization rate plummeted from close to 90% prior to the 2001 recession to nearly 50% by the end of the recession as supply overwhelmed demand.

Figure 1

Source: Federal Reserve Board, Bureau of Census

Not only was there excess investment in manufacturing capacity but also in employment as too much of the economy's resources in terms of capital and labor were guided towards the technology sector. When the technology bubble burst, both the overinvestment in capital and labor were unwound.

Figure 2

Source: U.S. Bureau of Labor Statistics

Just as economists and the financial media were absent in warning the public of the bubble in technology and the stock market, they too were silent in raising the alarm bells for the bubble in housing. Again, while everyone on Wall Street and those in the housing industry were making money, who cared, right?

Low interest rates made homes affordable to much of the population, but simply being able to afford a home didn't make it a good investment as homes were grossly overvalued. Sadly, when bubbles are at their zenith, the notion of value and prudent investing goes out the door. Just as Wall Street analysts found creative ways to justify absurd PE ratios for stocks, home appraisers justified outrageous prices for homes. Household debt levels surged, pushing up median home prices relative to the median family income as home prices got way ahead of themselves, a clear bubble to anyone looking at the facts.

Figure 3

Source: FRB: Flow of Funds

Figure 4

Source: U.S. Census Bureau

Just like the technology bubble, when the housing bubble burst, the overinvestment in terms of both capital and labor began to unwind and will continue to do so for a long time until the massive inventory of unsold homes can be worked through.

Figure 5

Source: BLS, BEA

Figure 6

Source: NAR, U.S. Census Bureau:

SHOW ME THE BUBBLE IN COMMODITIES!

As shown above, bubbles are often marked by periods of excessive investment where absurd valuations are justified. So the question becomes, if there is a commodity bubble then, where are all the excesses? Where's the extreme valuation within the sector? The simple answer to those questions is that there are no excesses and valuations still reflect pessimism, not rampant "this time is different" or "new era" mantra pushing multiples to extreme levels. Commodities are still climbing the wall of worry, which indicates a lack of a bubble and the bull market will likely continue.

No Bubble in Base Metals

Anyone calling for a bubble in base metals clearly hasn't been looking at excessive inventory levels and is likely looking solely at the price of base metals as justification for their bubbly claim. Simply looking at base metal inventories at the London Metal Exchange (LME) shows there is no bubble as inventories remain at or near record lows. It is the low level of these base metal inventories that justify the price increase as prices rise to bring supply and demand to equilibrium levels. Until excessive investment in base metal production increases inventories dramatically, there simply is no bubble in base metals. Anyone claiming that there is a bubble in base metals simply isn't doing their homework and needs only to be shown the charts below as their claims are as empty as LME warehouses.

Figure 7

Data: Bloomberg

Figure 8

Data: Bloomberg

Figure 9

Data: Bloomberg

Figure 10

Data: Bloomberg

Figure 11

Data: Bloomberg

No Bubble in Agriculture

As many in the press were calling a bubble in base metals due to the surge in their prices, rapid price increases in agricultural products are also being used to call them a bubble. The price increase seen in the agriculture sector is fairly broad based as shown by the various CRB indices below.

Figure 12

Source: Bridge/CRB

Figure 13

Source: Bridge/CRB

Figure 14

Source: Bridge/CRB

Though agriculture prices are at record highs, agriculture inventories are not. Several agriculture inventories are near record lows, not highs, justifying the price increases that have occurred over the last year. For example, world corn and barley inventories are at 20+ year lows, with world wheat inventories at 31 year lows.

Figure 15

Source: USDA

Figure 16

Source: USDA

The bubble in agriculture inventories is clearly absent as the industrialization of China and India continues. As these countries industrialize, their quality of life improves as do their diets. This leads to dwindling agriculture stockpiles in these countries adding further strain to world supplies that are already falling. These developments justify the price movements in both agriculture companies and agriculture prices as the developing world continues to consume any marginal increase in world agriculture output.

Figure 17

Source: USDA

Figure 18

Source: USDA

Only Excess in the Commodity Sector are the Bubble Calls

The excessive investment that was seen in both the technology and housing bubble is absent in the commodity sector, which is why the commodity bull market will continue. Some of the structural and fundamental underpinnings of the oil industry may sustain the bull market in energy for years to come. Unlike the past where shortages were created by manmade actions like war and oil embargoes, the current situation is due to demand outstripping supply.

Charley Maxwell, senior oil analyst from Weeden & Co, who has been in the oil business for almost 50 years provides the following commentary from a Barron's interview in 2006 conducted by Sandra Ward entitled, "Oil Prices: A Pause, Then Up":

We often say there are not a lot of advantages to getting old except that we have seen it all before. After a big move upward, there is always some counterreaction. We saw it during the 1973-74 crisis, in the '79 to '86 crisis and then in the two wars with Iraq. These crises were manipulations of the oil market by human beings. War, economic problems, but particularly military considerations, were creating, as they say, facts on the ground that worked into shortages that were real, but they were shortages created by the actions of man not nature. It is terribly important to differentiate between past periods and now.

[-]What came out of the 1986-1987 collapse in prices was a huge overcapacity of about 20% in the world's oil production system. The international oil companies began to adjust their capital spending quickly to adapt to that and they more or less serviced a 1% increase in demand each year. The capacity surplus began to come down naturally. We have now had 20 years and taken that surplus down to about 2% to 3%. For efficiency in the energy industry, given the weather factors and political factors and so on, we need something in the 7% to 8% range of excess capacity in order to cover the mountains and the plains of demand and weather and political events. But when the surplus got down to those levels between 1997 and 2000, the companies didn't add to capacity at a fast enough rate.

[-] We are now getting a reaction to the higher oil prices. It is translating into slower economic growth and, of course, it is allied with a rise in interest rates. Don't think that it is just that rising oil prices equal lower economic growth. It is a question of rising oil prices and less liquidity and higher rates that's a triple threat. The bottom could be in the high 40s, though that wouldn't be sustainable. On a yearly average, we will stay in the 60s, but we'll spend a lot of time in the 50s. Then they'll start up again in 2008-2009 and go up for some time. When we get to 130 or 150 there will be another pullback.

[-] In 1930 we found 10 billion new barrels of oil in the world and we used 1.5 billion. We reached a peak in 1964 when we found 48 billion barrels and used approximately 12 billion. In 1988, we found 23 billion barrels and used 23 billion barrels. That was the crossover when we started finding less than we were using. In 2005, we found about 5 billion to 6 billion and we used 30 billion. These numbers are just overwhelming.

Not only are oil companies finding it more difficult to discover new supplies to keep up with demand but various structural issues are constraining their investment. Run away inflation and labor and equipment shortages are hampering commodity-related company's ability to bring supplies on line. A Bloomberg article released on December 12th of 2006 entitled, "Rig Shortage Slows Chevron Bid to Tap Offshore Fields," demonstrates the tight supply of offshore rigs and the higher rates drillers are able to command as a result, with commentary from the article provided below (emphasis mine):

A global shortage of deep-sea drilling rigs is costing Chevron precious time as it taps the Gulf, and the equipment deficit may keep oil prices high. A prime example is the $3 billion field dubbed Jack. Chevron and partner Devon Energy Corp. announced the deepest-ever well test there on Sept. 5 (2006). Politicians backing energy independence exulted. Investors sent Devon shares up 12 percent and Chevron's up 2.3 percent.

They didn't know the drilling rig Cajun Express had already plugged the Jack well and moved to another urgent job. Drilling at Jack won't resume until at least July (2007), Thornburg (a senior drill-site manager for Chevron Corp.) says.

"There's a lot of prospects out here we'd like to drill but can't yet because there aren't enough rigs,'' says Thornburg, 58, who's overseeing drilling at another site, called Tahiti, that needed the Cajun Express to meet a more pressing deadline.

The Cajun Express is one of just 18 rigs worldwide capable of tapping the deepest discoveries. For the test at Jack, the platform-shaped vessel, which motors from site to site, needed to drill 4 miles (6.4 kilometers) below the sea floor.

Rental Fees Double

The Cajun Express is owned by Houston-based Transocean Inc., the world's biggest offshore driller. While record lease rates of as much as $520,000 a day are funding expansions by Transocean and other rig operators, shipyards from South Korea to Singapore to Scandinavia are backlogged with orders. Growth of the offshore drilling fleet will be gradual, says Kenneth Sill, a Houston-based analyst at Credit Suisse Securities USA LLC. Daily rental fees on the most sophisticated and rugged drilling vessels are double 18 months ago, Sill says.

"Day rates have climbed aggressively because demand for these rigs far outweighs the ready supply," says Clayton Ballard, the top-ranking Transocean employee aboard Discoverer Deep Seas, another rig at the Tahiti field.

Worldwide, there are 31 rigs on order that will be able to handle deepwater projects such as Jack, according to Houston-based Rigzone, which compiles data on the drilling industry. Two are scheduled to be finished next year and 13 are slated for delivery in 2008.

$1.5 Billion Order

Earlier this year, Chevron ordered two new rigs from Transocean at a cost of about $1.5 billion. They will be able to drill a mile deeper than the most sophisticated existing vessels. The first of the new vessels, which at a cost of $670 million will be the most expensive rig in history, won't be ready until 2010. Transocean will own the rigs and lease them to Chevron.

Even when available, the rigs are costly to operate. Chevron and its partners on the Tahiti field, Statoil ASA and Royal Dutch Shell Plc, are spending $1 million a day to rent, staff and supply the Cajun and Discoverer Deep Seas with fuel, food and hardware. The price tag will rise to $1.6 million a day by the end of this month as more cost-intensive phases of well preparation get under way, says Donald LeGros, Tahiti's drill site manager and Thornburg's No. 2.

"If people wonder where their money goes when they're paying $2.50 a gallon for gasoline, this is it," says LeGros, 45, who began working in oil fields the day after he finished high school in 1979.

In addition to equipment shortages and equipment inflation rates that are limiting increased commodity output is a lack of labor within the sector that is leading to high wage inflation. An entire Observation was devoted to addressing this issue entitled, "Global Distortions: US Dependency Goes Beyond Energy." During the great bear market in commodities that began in the 1980s and carried into this decade, very few college entrants dreamed of becoming engineers and geologists to work in the commodity sector, but instead poured into finance and technology related degrees. This has created a vacuum in available talent that will only get worse with the retirement of many existing engineers and geologists that received their degrees in the last commodity bull market of the 1970s.

The massive demand on the commodity complex in the 1970s lead to lucrative high paying jobs in the sector that saw total natural resource and mining employment nearly double in the decade, with the sector's employment reaching 1.4% of total national employment. As the commodity bubble in stocks burst, so did the bubble in commodity-related employment that was cut in half over the following decades.

Commodity-related employment has once again begun to pick up again as commodities are undergoing another bull market. However, commodity-related employment is nowhere close to the levels of the last peak with employment reaching only 0.55% of total nationally employment. This is roughly a third of what it reached in the last bull market indicating we are a long ways off from excessive human capital investment in the industry, at least here in the U.S.

Figure 19

In a decade of stagnant incomes that David Leonhardt describes in his article, "For Many, a Boom That Wasn't" the natural resource sector is bucking the trend. Commodity-related employment wage inflation has exceeded the average CPI inflation rate with current weekly wages up roughly 33% from their lows in 2003. Those within the sector will continue to benefit from rising wages as there remains a shortage of labor that will only be compounded by future retirees.

Figure 20

Source: David Leonhardt, The New York Times, 04.09.2008

Figure 21

Source: U.S. Bureau of Labor Statistics

Also absent within the commodity sector are bubbly valuation multiples. The bull market that began in the commodity sector early this decade has been entirely earnings driven as valuation multiples remain near twelve year lows as shown below for an equally weighted index of the stocks within the Amex Oil Index (XOI). There clearly is no bubble in the energy stocks with the energy sector sporting the lowest PE multiple of the ten S&P 500 sectors, currently at 13.14.

Figure 22

Source: Ford Equity Research

In addition to low valuations, the commodity sector is still ignored in terms of market capitalization. Typical bubbles are marked by everyone joining the bubble bandwagon, pushing up the sector's weight in the S&P. This was seen in the energy bubble in the 1970s and technology in the 1990s. Both sectors experienced a dramatic increase in their weighting in the S&P 500 as they attained bubble status and public fanfare as shown below.

Figure 23

Source: Barra

Figure 24

Source: Barra

Energy nearly reached 30% of the S&P 500 weighting during the 1970s bull market while technology breached the 30% level in the last decade. Looking at the energy sector above, commodities are nowhere close to the bubble status that they reached in the 1970s, or the level that technology did in the 1990s. The bubble simply isn't there as the public fanfare and bandwagon remains absent.

As shown above, the only excess seen in the commodity sector are the endless bubble calls that always run rampant when commodity prices rise dramatically. The likely reason for why few called for a bubble in the stock market in the 1990s and housing this decade was that most were able to enjoy the benefits of the bubble in terms of asset inflation. In contrast, few benefit from the rise in commodity prices as the public at large avoids investments in commodities like the plague due to their volatility and overall fear of this investment class. The broad public is not alone in their sentiment as money managers have been trained over the last two decades to focus on paper assets and shun hard assets, a profitable trade that has worked well since the disinflationary environment that Paul Volker brought about by breaking the secular trend in inflation in the 1970s. While only a marginal percentage of the public benefits from rising commodity prices through direct investment in commodities or commodity-related stocks, everyone is hurt by rising commodity prices that take a bite out of consumer wallets. It is for this reason that commodities are demonized and readily called a bubble. In the future, whenever you hear someone call the commodity bull market a bubble, simply tell them the following:

Show me the bubble in inventories!
Show me the bubble in capital expenditures excluding inflation!
Show me the bubble in employment!
Show me the bubble in valuation multiples!

Today's Markets

The markets succumbed to selling today, weighed down by a surge in crude oil prices that resulted from a bullish inventory report from the Department of Energy that said oil inventories fell 3.1 million barrels last week, more than the 2.3 barrel build that was expected, a difference of 5.4 million barrels between the actual and estimated change.

The rise in energy prices as well as a decline in the dollar, which fell 0.53% to 71.85, lifted other commodities. Gold had a strong day rallying $20.70/oz to $934.70/oz (2.26%), while silver rose 2.89% to $18.22./oz.

The Dow Jones Industrial Average fell 49.18 points to close at 12527.26 (-0.39%), the S&P 500 lost 11.05 points to close at 1354.49 (-0.81%), and the NASDAQ shed 26.64 points to close at 2322.12 (-1.13%). Declining issues represented 69% and 70% for the NYSE and NASDAQ respectively, reflecting a mostly down market.

Chris Puplava

Contact Information

Christopher M. Puplava
PFS Group
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