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. Last Updated: 07/27/2016

Living With Cheap Oil

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The deflation of the real estate bubble began with a weak link -- the subprime segment of the U.S. mortgage market among poor homeowners who were unable to service their loans. It is now spreading into other market segments in the United States and abroad, for example, into the overbought residential property market in Britain.

But the real estate bubble is only one of several bubbles that have appeared in the world economy since the start of this decade. Others include the stock market bubble, which has so inflated wealth that all 400 richest Americans on the Forbes list are now billionaires. This year, the "poorest" member of this club was worth $1.3 billion -- one-third more than in 2006.

The stock-price bubble has been even worse in emerging markets. A rally on the Mexico City bourse has turned Carlos Slim, the owner of Telmex, the telecoms monopoly, into the world's richest man.

Economists have been at pains to explain the price run-up in each of these markets. Real estate prices have been rising because the baby-boom generation is maturing and a new class of homeowners has been created thanks to cheap mortgages. Fine art prices have been bid up because new museums are being built all over China and the Middle East. Stock prices have also risen because profits growth has been so strong.

But when so many asset classes are hitting the stratosphere all at once, another factor is likely to be at work, namely the loss of value of money. Instead of a series of unrelated bubbles, the world economy is experiencing one general bubble -- the surfeit of liquidity.

Commodity markets have also been in a bubble stage, their prices rocketing due to cheap and plentiful liquidity. Oil being a bellwether of other commodities, the oil market has been the one where the bubble is easiest to identify.

Undoubtedly, since the end of the 2001-02 economic slump there has been a strong rise in global demand for oil. Most nations, industrial and emerging ones alike, use more oil. The main culprit is China, where demand for oil jumped from 4.8 million barrels per day in 2000 to 7.3 million barrels per day in 2006.

But oil output also rose strongly over the same time period, with Russia alone now producing 3 million barrels per day more. Even if oil supplies have tightened since the end of the 1990s, when its price bottomed out at around $10 per barrel, it certainly doesn't justify a tenfold jump in oil prices.

Today, the bulk of the world's oil is sold through the futures markets, where players are not users or producers of oil but speculators. They should be looking not so much at today's supply-demand relationship but at future trends in the market. The longer term outlook for oil prices appears to be grim. Oil reserves have been boosted by recent offshore finds as well as the inclusion of Canada's tar sands into its proven reserves. Oil recovery rates from new and existing reservoirs have increased due to new technologies. Moreover, at $100 per barrel, new sources of supply constantly emerge, and development of new technologies for energy conservation and alternative energy sources becomes more attractive. Currently, tens of billions of dollars are being invested into new oil exploration and production.

The real estate crisis is only the beginning. Once the U.S. Federal Reserve and other central banks tightened their monetary policies, the pricking of the liquidity bubble was set in motion. Stock prices have been volatile, and volatility has spread into the oil market since the start of November. Late last month, oil dropped by 15 percent in a few trading sessions. Even though it has bounced back, oil producers -- and certainly Russia -- should get ready to live with substantially lower oil prices.

Alexei Bayer, a native Muscovite, is a New York-based economist.