In the late 1990's and early 2000's massive amounts of investment cash poured into internet companies in the anticipation that the new technology would only continue to grow, never retreat and always make lots of money. In the early to mid 2000's large amounts of investment cash chased real estate higher, because you know, they weren't making any more land and there is a finite amount of buildable space (yes, this is a facetious statement). Were these inflationary bouts? Yes, but only in the literal sense of the word. Economically, inflation is a supply and demand issue and never an excess cash issue. That is why when governments pump cash into their economic systems it is not inflationary, it is only inflationary when that cash changes hands a lot of times (increase in velocity of money); hence “demand” to move the supply of cash. Without demand for cash supply is meaningless.

During the “Dotcom” bubble there was never a supply issue, new companies were being born every day. Demand was not the issue because the internet had not yet garnered enough users. What did drive prices was speculation for future products and users; speculation that got too far ahead of itself.

Before the real estate boom everyone wanted to own their own house, condo, whatever. Not just in the U.S. but everywhere. Peoples’ need for comfortable housing is universal. Nothing has changed; everyone still wants to own their own home. The difference during the housing boom was banking regulations changed allowing more people to qualify for mortgages. Now we look back and call it a pricing bubble. Demand is still the same, everyone still wants to have their own home, but new mortgage regulations disqualify most buyers. During the housing boom there was not an overnight population increase (increase in demand) nor were there suddenly fewer homes available (decrease in supply). As a matter of fact there were more homes as builders produced more and there certainly was no overnight population explosion causing more demand. There was simply less regulation allowing demand to actually take action.

Currently, and for the past 6 years, commodities have been all the rage; oil, food, building materials. Prices for crude oil have risen and fallen sharply and then risen again. Food prices started a slow creep 6 years ago and have now accelerated their climb to the point where poorer nations cannot afford many food staples. Let’s take a look at some statistics:

Of all the recent commodity price increases crude oil is the easiest to understand and has the most available statistics. So, we will examine its price moves. Let’s start with 1995 because the average price for crude oil for that year was $16.75/barrel. This price is very close to the average price over the past 65 year period, $16.62 per barrel. Additionally, statistics are readily available for this time period from the International Energy Agency (see http://omrpublic.iea.org/omrarchive/sup2010.pdf - page 4). Consistently since 1995 supply has kept up with demand. In 1995 the world produced 70.7 million barrels of oil per day while consumption averaged 70.1 million barrels per day. Now in 2009, the latest year for which there are statistics, the world consumed an estimated 84.9 million barrels per day while production was 85.0 million barrels per day. Every year in-between supply always met demand or was just slightly higher or slightly lower. Pricing over this period has been wild to say the least (see table and graph below).

Click on image to enlarge!

Click on image to enlarge!

Starting in 2004 oil began in the mid $20 a barrel range and climbed to over $140 per barrel in mid 2008 only to decline to almost $30 per barrel in late 2008 early 2009. Now it is once again above $110 per barrel while global supply is meeting global demand. Why the large price gyrations? Is this inflation? Yes, in the literal sense it is, but it is truly a Pricing Bubble just as with the “Dotcoms” or real estate. Large amounts of cash are chasing an “investment” in crude oil speculating that supply will not meet demand. And, at the current moment that speculation premium is saying the world will not even come close to meeting demand requirements.

We can go back 65 years and produce a regression analysis to project prices based on an average inflation rate of 3.95%, presuming supply meets demand just as it has for the last 65 years. And, we can conclude that for the year 2011 crude oil should be trading between $26 and $34 per barrel. Given that supply meets demand, as it has for the last 65 years, the pricing bubble in crude oil is about 4 times its inflation adjusted price. There is a similar speculative premium built into many food items and building materials, not as easily quantifiable as crude oil but none the less still a pricing bubble.

There are many factors that we have not examined in this article that can and do influence price increases and decreases. However, those factors are never the cause of Pricing Bubbles, the cause is always speculation.

To learn more from Tim, please visit his website at FXAddicts.com.