Shanghai Bubble Finally Bursting?

As I have mentioned before, the Shanghai Stock Exchange has had one of the biggest bubbles in history over the last two years. The SSEC index has gone up from a low of 1067 on 28 October 2005 to a high of 6124 on 16 October 2007, an increase of 474% over less than two years!

Click the graph for a larger version.
Since then it has declined to close at 4861 on 27 November. Is this drop of more than 20% the popping of the bubble, or just another false alarm? There have been two previous big scares for Chinese investors this year, the first one in February-March, the second one in June-July, but the Shanghai Stock Exchange recovered from both of them and kept on chugging upwards. However, this latest drop is bigger (percentage-wise) than any of the previous two. If it continues, we could very well see one of the most epic stock market crashes in history.

Internet Bubble Version 2.0

Don't think the Internet bubble of 1999-2000 scared all investors away from hyperinflated Internet stocks. I'm thinking of for instance Google, currently trading at $660 per share. Alright, down a good bit from the top of $742 two weeks ago, but still dizzyingly high at a price/earnings of about 52. This means that if they manage to keep their earnings as high as now and give all of their earnings back to their shareholders (which they of course don't), it would take about 52 years for a shareholder to get his money back in dividend. Now, what if earnings start dropping, with a recession coming on? Other Internet bubble stocks right now are Amazon, with a price/earnings of about 93 (!) and Yahoo, with a price/earnings of about 50. Price/earnings this high of course means that the markets expect the earnings to increase, but just how many more advertisers want to advertise with Google or Yahoo? Or are they going to pay more for advertising there? And how many more books and CDs can Amazon sell per year? Or are they going to take higher profit margins on each sold book?
For comparison, Microsoft and Cisco both have a p/e of 22, which is still considered to be on the high side. How long would you like to wait to get your invested money back? 22 years? Make that 10 and it starts to sound like a reasonable investment.

100 Dollar Oil Soon?

I don't think anybody has missed the fact that oil prices have risen sharply over the last years. This is not only due to the drop in the dollar, but mainly caused by supply not keeping up with demand. Last spring the world had an "oil shock" when prices of crude oil (WTI) went above $75 per barrel for a while. Then prices dropped back to as low as $50 per barrel in January 2007, only to continue their climb all through the year. WTI oil was up to $98.50 per barrel on 7 November, then fell back to just above $90, and then went back up again to $99 per barrel yesterday morning, and fell back a bit later during the day.
Here's a graph of WTI oil prices since January 2006 for you:
Today, trading in oil is probably not so heavy in the USA, due to the Thanksgiving holiday. However, the North Sea Brent oil jumped up by $4 per barrel today, so if the same trend continues tomorrow, we might very well see WTI oil over $100 dollars then. This is probably a very important psychological barrier, and might cause serious repercussions across financial markets. Expect all major newspaper to have $100 oil as first page news the day after it hits us.

Oil is a major driving factor behind today's inflation, so expect to see higher inflation. Oil prices affect the price of everything. Not only will filling up your car be more expensive, but also air travel, food, and everything else. It will take longer time for the higher oil price to trickle through into some areas, but eventually it will raise prices of everything, because oil is needed to produce stuff, to transport it from the factory to the consumer, to build new factories, to build and maintain infrastructure (e.g. railways, roads, sewers). Air, car and diesel train travel will of course be hit rather fast by higher oil prices. In the long run, however, electric train travel will become more expensive too, even if the electricity comes from hydropower plants. This is because the maintenance of the railways requires diesel-driven machines. New locomotives, carriages and wagons also require oil to build them, to run the mining equipment for the raw materials, etc. In the end, maintenance of hydropower plants also requires oil.

There has been speculation over how much the price of oil has been inflated lately by hedge funds and other investors speculating in oil futures. However, there is a simple reason for the higher prices, and that is supply. The International Petroleum Monthly for October from EIA provides the simple answer that world oil production has actually declined since the top in July 2006, see chart below:
Meanwhile demand is increasing steadily, especially in places like China. The supply situation is most likely not going to improve other than temporarily, since it seems we have actually passed "peak oil" now. Many experts believe this, among them Matthew Simmons. So how is the world going to solve this problem?

• If you think nuclear power is a solution, just take a look at how uranium prices have increased over the last years. And don't forget that since 1985, uranium production has not kept up with demand. The gap has been filled by stockpiles mostly from military sources, but that cannot go on forever.
• If you think wind power is a solution, just contemplate that it would take 3 million large "wind mills" to replace the 85 million barrels of oil used per day in the world today.
• If you think hydropower is a solution, remember that there aren't all that many rivers left to harness around the world. And do we really want to sacrifice the last free running rivers?
• If you think solar power is a solution, maybe you should be aware of the fact that the silicon required to produce them is in short supply in the world today, and the situation is not likely to improve over the next couple of years.
  
• Biofuels are out of the question as a replacement, because even if we used all available farmland, we would still only be able to replace a few percent of the oil used today.
• Natural gas is not a very good replacement for oil either, because it is becoming more expensive too.
• Coal might be a feasible replacement for oil for a decade or two, before supplies start declining there too. However, it is very dirty!
• Saving energy is a solution. There are lots of ways the world, and especially the rich countries in the world, can save energy.

Higher oil prices will force the world to use energy more efficiently, but will create a lot of economical havoc in the process. Be prepared for $100 oil, and then $150 oil, and then $200 oil.