Saturday, July 12, 2008

Oil Bubble?

As politicians blame rising oil prices on speculators, it's worth reviewing the counterargument made by Princeton University economist Paul Krugman. Krugman says today's high oil prices are based on actual supply and demand, not financial speculation. Krugman correctly recognized both the late-1990s' stock market bubble and the housing bubble, so the fact that he argues that there is no oil bubble is ominous.
Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble?

Now, speculators do sometimes push commodity prices far above the level justified by fundamentals. But when that happens, there are telltale signs that just aren’t there in today’s oil market.

Imagine what would happen if the oil market were humming along, with supply and demand balanced at a price of $25 a barrel, and a bunch of speculators came in and drove the price up to $100.

Even if this were purely a financial play on the part of the speculators, it would have major consequences in the material world. Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production.

As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again — unless someone were willing to buy up the excess and take it off the market.

The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding — an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.

But it hasn’t happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices these past few years had to happen to keep demand growth from exceeding supply growth.

Saying that high-priced oil isn’t a bubble doesn’t mean that oil prices will never decline. I wouldn’t be shocked if a pullback in demand, driven by delayed effects of high prices, sends the price of crude back below $100 for a while. But it does mean that speculators aren’t at the heart of the story.
For anyone interested in the whole oil speculation issue, Economist's View has been covering it.

Any thoughts from readers?


  1. If what you are saying is true, then this scenario will play out: We drive less but the price of gas continues to rise because of those pesky Chinese and Indians. Because gas prices continues to rise, the price of just about everything else - food, cothing, electricity -goes up with it with no end in sight.

    Can you say recession?

  2. This begs the question: "What will happen to long-term real estate values for properties near passenger rail, major employment centers, and within walking distance of amenities like supermarkets and movie theaters?"

    Conversely; "what will happen to exurban & suburban real estate values, long term?"

  3. I'm no petroleum geologist, but yeah, the increase in consumption over the last century is staggering. There's nothing replenishing those reservoirs at anything like the rate at which they're being drained. And for all the hoopla about this or that big reserve that's gonna solve everything(ANWR, offshore Brazil, etc.), I seldom hear any acknowledgement of how each new source requires more and more capital investment. Think this trend can go on forever?

    I suspect that gonzo consumer corporatism, er, I mean "capitalism", is entering its sustainability crisis. Fifty years from now (if not sooner) I expect that whatever it is we call "the American way of life" will be as discredited as Soviet Communism.
    -- sglover

  4. Part of this is correct, and the scenario as the professor portrays here is being played out. Drivers are consuming less (in the US), people are using less energy but production is not increasing. The WINNERS are still the energy producing companies. There is NO incentive for them to increase production. None. They sit there, produce less, their cost decreases (because of lower production) and the prices show their profits going through the roof. Anonymous said that the American way of life could be going by the wayside. That prediction appears more true than anything else on this page.

  5. I might disagree with this article. infact the demand is being met. but the only way to get the price to go down is too flood the market with surplus oil reserves. OPEC refused to increase the supply at George Bush's request, but OPEC refused, not because they could not increase production, but because they were currently meeting the demand.OPEC is the one getting Rich. By keeping the demand barely met, they can keep speculators worried, prices stay high and they make more per barrel. If you were OPEC would your rather make post gulf war numbers of $27.00 a barrel or current numbers of $150.00 per barrel. Where is OPEC's incentive to increase production. they could care less about our rising cost of inflation.

  6. The drilling in the Bakken formation will certainly have an effect on oil prices