In 2000, investors thought the world was a “different” place. “You have to value Internet companies differently,” people would say. “Ignore the triple-digit P/E… That is an obsolete way to value a company.”

But they were wrong. The Datastream Internet Index reached its peak on January 3, 2000, and then collapsed, falling 93.8% over the next 34 months.

In 2005, investors thought the real estate market was “different.” Homeowners were buying houses more expensive than they could afford because they thought inflation would protect them. While home prices could stagnate, they wouldn’t go down.

But, as you know, they were wrong. Beginning July 2006, real estate has fallen 16.2%.

Investors will come up with any excuse to continue pumping money into a sector that’s produced amazing returns for them in the past. And when the money starts piling in, it’s time for you to get out.

Today, the sector is oil. In inflation-adjusted terms, the price of oil is up 140% in the last 18 months. At first glance, the logic seems plausible…

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Global demand for oil is surging. Most of this increase comes from emerging economies like China and India. And global oil supply is on the decline. A large cause is poor reserve management by nationalized oil companies.

Venezuela’s oil production, for example, decreased by at least 1 million barrels per day (bpd) since President Hugo Chavez nationalized the country’s oil fields between mid-2006 and 2007. And Iran’s leaders can’t attract private capital and technology, so production is down 3 million bpd to half of what it used to be under the Shah.

Russia and Nigeria are in the same boat… The problem is, high oil prices make governments greedy. They take over oil fields and mismanage them, decreasing supply growth… and leading to even higher oil prices.

This imbalance has catapulted the price of oil to stratospheric levels. Even when adjusted for inflation, the price of crude oil is now far above its 1980 peak.

In the long run, simple economics tells us the price of a barrel of oil should equal the cost of producing the most expensive barrel of oil needed to meet global demand.

According to the Energy Information Administration (EIA), the oil market has a small surplus of existing production. And according to a Dallas Federal Reserve economist, the most expensive barrel of oil needed to meet global demand is being produced at just $50. With oil currently priced at $137 a barrel, the incentive to find and produce more oil is enormous.

This process takes time… But there are already signs supply is climbing. Shale oil in the Dakotas and in the Canadian tar sands – which costs about $70 a barrel to produce in both places – is attracting enormous amounts of investment capital.

In addition, research into the process of converting coal to oil might yield a more environmentally friendly process sometime in the near future, which would overcome one of the major hurdles facing coal-to-oil production now. The supply of coal in the U.S., if you were wondering, is plentiful.

From the demand side, the EIA reports consumption in 30 developed countries has fallen 460,000 bpd since last year. Most of that decline comes from plummeting U.S. demand.

This commodity rally – and the oil boom in particular – is not any different than previous booms. The market will find a new equilibrium, and the price of oil will undergo a nasty correction.

Good investing,

Ian

P.S. As my colleague Matt Badiali explained in a recent DailyWealth essay, don’t confuse brains with a bull market. If you own oil and gas stocks, now’s the time to keep an eye on your stops. On the other hand, the market has mauled refiners. But I think right now, refining stocks are perfectly positioned for the coming oil rout.

Source:  Why Oil May Be Headed for $50