Monday, May 19, 2008

Oil Bubble

Charles Engel wonders whether there's an oil bubble (via Econbrowser):

One possible explanation is that the market has kept learning about the strength of demand and the weakness of supply over the years. It is consistently being surprised, in other words. That may be right, but it is a shaky argument: why is the market always being surprised in the same direction – that excess demand is greater than we thought? Another story that I think makes some sense is the one that Jeffrey Frankel and Jim Hamilton have promoted – that Fed monetary policy has played a role. [A] drop in real interest rates should cause commodity prices to rise. But here again, the decline would also have to be unanticipated to explain the continual increase in the price. I think there is a lot of truth to the view that markets keep getting surprised in the direction that makes oil prices higher. ... The problem for economists is that the market for oil is so complicated that we cannot very accurately calculate what the price of oil “should be” if there is no bubble. We have to read the entrails to figure out whether the price is really reflecting market fundamentals – demand, supply, real interest rates – or has a bubble component. As I look at the rising price, I wonder which story is most plausible: (1) the markets have been surprised over and over about demand by end users and production capabilities; (2) markets have been surprised over and over about how low real interest rates are; (3) there is a bubble. These stories may go together, in fact.
The story about the market consistently being surprised is more believable if you think about it not in terms of the market being surprised over and over again in one direction, but rather the market being surprised in one direction more often than it's being surprised in the other direction. Look at the price of crude oil over the past 6 months:
Clearly, the market has been "surprised" in both directions over the past 6 months -- it's just been surprised in the direction of higher prices more than it's been surprised in the direction of lower prices. I'd be willing to buy this story as the explanation for increasing oil prices (rather than a speculative bubble). But just as intraday movement in stock prices reflect liquidity concerns rather than information being priced in, I'm not sure that most of the movements in oil prices don't reflect major liquidity issues -- especially as the credit crunch has made liquidity such a dominant issue. As far as I'm concerned, there's probably a bubble in agricultural commodities, but the jury is still out on whether there's an oil bubble. Oil is a unique beast, and cannot be lumped together with all of the other commodities. The debate over whether there's an oil bubble is fascinating, and is taking place at a considerably higher level than the debate over whether there was a housing bubble. (I'm just waiting until the hysteria and irrationality kicks into the oil bubble debate, because you know it will eventually.)

1 comments:

Juan said...

EoC,

Sorry if this excerpt is a bit long. For context sake, you may wish to read the entire paper:

The current market-related oil-pricing regime is based on formula pricing, in which the price of a certain variety of crude oil is set as a differential to a certain marker or reference price. The emergence and expansion of the market for crude oil allowed the development of market-referencing pricing off spot crude markers such as spot West
Texas Intermediate (WTI) (initially Alaska North Slope), dated Brent and Dubai. The declining liquidity of the reference crudes has, however, raised doubts about their ability to generate a marker price that accurately reflects the price at the margin of the physical barrel of oil. First, it is often argued that thin and illiquid markets are more susceptible to distortions and squeezes. Second, in such markets where actual deals are infrequent and irregular, the number of price quotations for actual transactions is quite small. But for crude oil to act as a reference or benchmark, price quotations should be generated on a regular basis. ...

The declining liquidity of the physical base of the reference crude oil and the narrowness of the spot market have caused many oil-exporting and oil-consuming countries to look for an alternative market to derive the price of the reference crude.
The alternative was found in the futures market. When formula pricing was first used in the mid-1980s, the WTI and Brent futures contracts were in their infancy. Since then, the futures market has grown to become not only a market that allows producers and refiners to hedge their risks and speculators to take positions, but is also at the heart of the current oil-pricing regime.

(Oxford Institute for Energy Studies, WPM 31
March 2007)
http://www.google.com/search?q=cache:uPy8mJ-FgZ0J:www.oxfordenergy.org/pdfs/WPM31.pdf+oxford+institute+for+energy+studies,+WPM31&hl=en&ct=clnk&cd=1&gl=us&client=safari

My point? Simply that price for this particular commodity is formed not so much on neoclassic supply/demand basis but trade in financial instruments - which also opens price formation to self-fulfilling socio-psychological pressures and self-justifying stories that may not accurately capture real economy conditions; artificial price can come about and all the moreso given the flow of funds we've seen gathering momentum since no later than early 2004.

From a price perspective, trade in the physicals remains important, simply less so than most often considered.

Regards