A Paradigm Shift in the Oil Market

By Markets Editor Andrew Van Sickle May 30, 2006

Andrew Van Sickle

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Renowned investor Jeremy Grantham, chairman of Grantham, Mayo, Van Otterloo (GMO), studies bubbles “much like a biologist might track and tag endangered species”, notes Eric Fry on the Rude Awakening. He has examined 27 bubbles in stocks, bonds and commodities, and in each case he has found that valuations revert back to the average, sending prices back to the trend that existed before they skyrocketed. So when Grantham reckons he’s found an asset class that “has witnessed a paradigm shift” (meaning it has transcended the natural order of markets reverting to the mean), investors should take note, says Stephen Schurr in the FT.

According to Grantham, for the century prior to 1974, oil averaged $16 a barrel in today’s currency, but when Opec began flexing its muscles, the trend line moved to $36. Higher trend oil prices are being sustained by soaring demand growth amid Asian industrialisation and tight supplies.

GMO defines a bubble as a rise of two standard deviations above the historic trend; a standard deviation (known as a sigma) is the gauge of the dispersion of a series of data from the average. If oil’s trend were still at $16 a barrel, the 1980 peak, when prices reached more than $80 in today’s dollars, would be a “5.2 sigma event”, a one in 11 million occurrence. The current record oil price of just over $60 would be a 4.2 sigma event. But with the trend line at $36, the 1980 high was just a two sigma event (a one in 40-year occurrence) and today’s oil is a mere 1.3 sigma event – hardly excessively above trend. Short sellers should hold their fire until oil hits about $80, says Grantham

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Published in Commodities | More articles by Andrew Van Sickle

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