13, 2008 -- From a low of $17.45 a barrel set in November 2001 to a high of $139.12 a barrel set a week ago, crude oil prices have rallied 697 percent. To grasp what a 697 percent rise in the futures market represents consider this; the margin for one crude oil contract in 2001, was around $1500 to $2000. With crude at its high point, in theory, that contract would have yielded profits of approximately $121,670.
Of course, no one would have actually bought the very low, kept rolling the contract forward and then be lucky or smart enough to have taken profits at the very high. Then again, oil producing countries such as Iraq, Saudi Arabia or Big Oil companies like Exxon literally caught the entire rally. They could have and more than likely were there for the entire ride.
The last time a similar market rise was seen was with the Nasdaq Composite Index. The rally started in June 1994 but did not peak until March, 2000 when it touched 5,132, rise of 640 percent. In the case of the Nasdaq, the rally turned out to be a bubble as prices tumbled 78 percent from their peak and have yet to recover. Billions of dollars were lost and some individual investors and traders were simply wiped out.
The collapse of the Nasdaq was nothing new as history clearly shows. In Great Britain for example, in 1711, stocks in the South Sea Corporation began trading with hoopla and hype and peaked at 1000 British pounds. By late 1720, the shares were worth nothing. Zero. The debacle became know as the South Sea Bubble and in recent years has been dubbed the, "Enron of England."
In Holland in the 1630's, tulip bulbs became all the rage and were traded on the stock exchanges of numerous Dutch towns and cities. In one month, the price of one single tulip bulb rose twenty fold as a $1,000 investment turned into $20,000. People began selling or trading their other possessions in order to speculate in the tulip market! Seizing an opportunity, Amsterdam stock exchanges in 1636 started offering "option" contracts to the public which allowed tulip bulbs to be speculated upon for a fraction of the price of a real tulip bulb. The creation of options and the leverage that comes with it allowed people of moderate to lower income to join in the speculation. And join they did as mania and speculative excess became the order of the day.
The leverage with options on tulip bulbs, allowed a $1,000 investment to balloon to $100,000. At this point, it was commonly believed the tulip market was immune to crashing as prices would, "always go up." Unfortunately, leverage is a double edged sword and when prices began to slip ever so slightly, the option buyers investment would be lost. Or, worst yet, they might even owe money.
At the height of the mania, in February 1637, one single tulip bulb traded as high as $76,000. Suddenly, the market psychology changed from manic to panic and the public began to sell aggressively. Those leveraged up to their eyeballs were caught and squeezed hard as buyers were suddenly non existent. Six weeks later the value for one tulip bulb was less than a dollar.
History is full of bubbles. Here are but a few; Mississippi Company of 1720, Victorian land boom of the 1880's, Florida building bubble of 1926, Sports cards and comic books in the 1980's and early 1990's, Beanie Babies of 1996, Japanese stock market of 1980's, Asian Crisis 1997, Chinese stock market of 2006 and the Indian stock bubble of 2007-2008.
Is there a common link between bubbles? There is indeed. The link is referred to as the, "greater fool theory." Bubbles are driven by overly optimistic market participants (the fools) who buy overvalued assets expecting to sell them to other participants (greater fools) at even higher prices. As long as the fools can find greater fools to pay up for the overvalued assets the bubble continues to expand. Once the pool of greater fools dries up, the bubble begins to leak air and the law of gravity quickly takes over.
There are bubbles in today's marketplace brought about because the U.S. dollar is weak and crude oil prices at record high levels. But if the dollar inflates and crude oil prices deflate as I fully expect, a number of high flying commodity markets some of which can viewed as bubbles are likely to roll over and crash.
This week, crude oil prices slipped 1.37 percent when Saudi Arabia announced plans to increase production. As crude weakened, the U.S. dollar managed to notch its best week against a basket of currencies since 2005. One week of strength with the dollar coupled with a week of weakness with crude oil does not make for a trend. But it certainly made for an interesting week. And this week should be more interesting yet.
(The information in this article is the opinion of Commodity Insight's Jerry Welch and subject to change without notice.)