Just as we were saying since the start of this website that shares were living on borrowed time, that the economy was way weaker than you would think looking at the markets, and that it would be a matter of time before stocks would price in properly the risks to the real economy, we have argued something similar for oil recently.

Basically our thesis is twofold:

• The economy, already in a very bad shape, is further hurting by high oil (and food) prices, this will have a negative impact on the growth for demand for oil soon, less economic activity means less energy demand, as simple as that
• The high oil prices themselves are changing behaviour which will, given time, slow demand and spur supply. The former will happen faster than the latter, but it will happen.

Now, just as reality has been catching up with stock prices, it will catch up with oil prices. It’s way too soon to call victory on our oil market predictions, but recent volatility (today, we saw a $10 per barrel sell-off in oil) adds to our arguments. It shows that the market is at a relative top and uncertainty on where it’s heading next is increasing.

One thing to keep in mind is that things can always turn around by some event, a terrorist attack, increasing political tension in the Middle East (remember those remarks by the Iranian president about extinguishing Israel a couple of years ago, apart from playing the domestic popularity card, these remarks stuffed the coffins of the Iranian state by creating more worries in the oil markets).

We did not argue that long-term, oil prices could not be higher. This crucially depends on proper investments being made in exploration and development. The main problem here is that the most significant resources which could be developed with a dollup of investment are under state control, and these states hardly have a big incentive to hurry up with these investments.

They enjoy the oil boom, buy policial support with it, it’s not in their interest to increase supply. Only the country that has the biggest reserves, Saudi Arabia, and therefore the longest time horizon, might have an incentive to care about the not so near future.

It’s possible they have learned the lessons from the two previous dramatic oil price hikes (1973 and 1979). Both helped plunge the world economy into a recession and led to a collapse in oil price and a significant weakening of OPEC.

This is not in the long-term interest of the Saudi’s. If they could, they would probably increase supply. But the 64B question in oil is, can they? Not everybody is convinced that they can put their recent declarations of increasing supply put to work. See here Business Week’s take on that issue.

All is not well there…

So, although we do think oil is close to it’s top in the relative short-run (until the economic problems start to ameliorate or some event causes a spike), for the long-term, we’re still fairly bullish.