ANOTHER RATIONAL EXPECTATIONS HYPERINFLATION? Lenders finance slum houses with nothing down and forever to pay on the expectation that the house price will double and the owner can refinance into a thirty-year fixed with the appraised value providing the equity. Oops. Investors purchase any company with an e-this or a .com that in its name that is actually reporting earnings at 300 times those earnings on the expectation that the company will show a 25-fold increase in earnings over the next 3 or 4 years. Oops. And now the oil price of a dollar is rising, in the expectation that oil today will be able to buy even more dollars tomorrow. Soon to be oops?

According to economist John Kemp at the commodities firm Sempra Metals, the U.S. consumed 4 percent less petroleum in January 2008 than it did the year before. [Citigroup's Tim] Evans agrees, noting that the U.S. demand for petroleum products began falling off last July. Interestingly, this drop in U.S. oil consumption began before crude prices turned vertical and before we began to see weakness in the broader economy. Even China's thirst for oil is abating somewhat. Its demand for oil, which once rose at 10 percent per year, has now dropped to 6 percent per year. In addition, world surplus oil production capacity has gone from a very tight 1.5 million barrels per day a couple of years ago to more than 3 million barrels today, says petroleum economist Michael Lynch.

So supply is up; relative demand is down and yet, the price of oil is soaring. What's going on?

Those who do not remember the past ...

Economist Richard Rahn from the Institute for Global Economic Growth believes battery technologies are improving so rapidly that the majority of cars sold in 10 years will be all-electric. This would certainly help drive down the price of oil. Supply is also inelastic—it takes a long time to do the exploration, drilling, and refining necessary to boost production in response to higher prices. This inelasticity of demand and supply means that petroleum prices are very sensitive to relatively small changes in either. This means that prices can fall as steeply has they rose.

Whenever you begin to hear market gurus decree that "this time it's different," as we did during the dot-com bubble and the housing bubble, that's a sure sign of danger in the market. Naturally, proponents of the peak oil theory claim that the recent run up in prices is evidence that the end is nigh. Evans responds, "Fears of peak oil are what this market has in common with the 1980s, not what is different." Recall that during the "oil crisis" of the 1970s when oil prices were as high as they are today, U.S. oil consumption declined by 13 percent between 1973 and 1983. The higher prices of the 1970s led eventually to an oil glut and prices fell to about $10 a barrel by 1986.

So what will happen to oil prices over the next few years? No one is predicting $10 per barrel oil. However, once the current bubble bursts, both Evans and Lynch believe that the price of crude will settle at around $60 to $70 per barrel in the next couple of years. "It's very hard to pinpoint just how long a bubble can expand before it breaks. Getting the timing right is not an easy matter," says Evans. But he adds, "I think that this is the riskiest time to be long in crude oil since 1980."

If one can anticipate, perfectly, when the bubble bursts, one can make large sums of money. It's also possible for sufficiently forward-thinking traders to make a transitory above-normal return on investment by being close enough to the right time.