Megan McArdle makes a key point about asset bubbles (a point that seems to elude 99% of journalists):

It is not enough to think that prices are going to rise; you have to think that they will rise more than everyone else thinks they will. Otherwise, the future appreciation should already be fully priced into the current asset. Failure to understand this--the belief that you can actually make a profit based on a certain rise--is the root of all bubbles.
This is why I find it so hard to believe that the dramatic run-up in oil prices over the past 17 months can be explained solely—or even mostly—by rising demand from developing countries, particularly China and India.

Rising demand from developing countries can explain high oil prices, but not rising oil prices. If the current high price of oil ($140/barrel) can be explained solely by increased demand for oil from developing countries, then the futures markets should have priced in the increased demand a long time ago—we've known for quite a while that developing countries would increase their demand for oil as they grew. The price of oil was around $60/barrel in January 2007. What do we know about the rising demand for oil from developing countries now that we didn't know in January 2007 (or for that matter, January 2005)? Virtually nothing—except that both China and India's growth has actually slowed a bit. But look what the price of oil has done:

To find out what's behind the run-up in oil prices, you have to figure out why the futures market has underestimated the spot price of oil over and over again for the past 17 months. There hasn't been any important new information about rising demand from developing countries for futures traders to price in. So something else has been driving oil prices up. The question is, what?

Here's where speculators could play a role. As the housing bubble has wreaked havoc on the financial markets, investors seeking higher returns have flocked to commodities—particularly oil. The vast majority of these investors are brand new to commodities. They're just looking for high returns, and oil futures have been providing high returns ever since the investors started to flee the mortgage market (and all other investments tinged by mortgages). This is a possible explanation for the rising oil prices because the subprime crisis unfolded slowly, and thus new investors have been constantly moving into oil.

Each successive wave of investors flooding into oil futures would have very little specialized knowledge of the oil market. Moreover, the reason these investors were buying oil futures was the belief that oil prices were rising. So the vast majority of these investors would have been long oil, thus driving oil prices ever higher.

Now, I don't think this is the whole story by any means. I just think it's a conceivable explanation for rising oil prices over the past 17 months—it's a more believable explanation that just "rising demand from China and India," at least.


Anonymous said...

Here is an interesting site called GasBankUSA and talks about fixed price gas. The site is located at

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