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Does the high oil price reflect a bubble?
Paul Krugman writes (and here):
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.
I've never been one to push the bubble hypothesis to explain the high price of oil but I find this an unusual argument to make against bubbles. Isn't it easy enough to argue that the relevant hoarding is of oil in the ground rather than oil in strategic reserves or panic stockpiles? We have lots of state-owned oil companies and maybe their way of speculating is simply to remain sluggish in their exploration and extraction activities, at least for the time being.
I think of a bubble as a market price which is above the fundamental value of the asset, largely for psychological reasons. But with a commodity like oil the fundamental value of the asset depends on the marginal unit and thus how much oil is supplied. Fundamental value, at least at the margin, adjusts to the price and in that sense the bubble hypothesis can seem tautologically false if we apply the traditional definition of a bubble.
The key question, in my view, is how much more the oil-producing nations could bring to the market if a) their state-owned oil companies were not incompetent, and b) they did not tolerate this incompetence as an implicit form of speculation and collusion. I will not offer an estimate here (I genuinely don't have one) but b) does leave some room for bubbly-like phenomena, whether or not stockpiles of pumped oil are high. Note that in b) collusion and speculation work together and a) tosses incompetence into the mix. The whole foul brew is probably easier to sustain in times of rising demand and thus oil price explanations are not going to be very simple, or easily separable, by the nature of the problem.
Addendum: Read Arnold Kling, here and here.
Posted by Tyler Cowen on May 13, 2008 at 05:47 AM in Economics | Permalink
Comments
A number of people made this argument on Krugman's page. But this argument proves too much: we could never distinguish between genuine scarcity and this expanded concept of hoarding.
Posted by: michael webster at May 13, 2008 7:30:17 AM
While incompetent can't be ruled out maybe they are crazy like a fox.
Assume one state owned company owned all of a commodity if they produced 100 units the price would be $10/unit and it had a linear relationship so that if they only produced 10 units the price would be $50/unit. This would result in a reduction by 1/2 for the state.
However if the threat of scarcity caused an exponential increase to $100/unit when only 10 units were produced they would be receiving the same revenue while reducing the amount of future commodity reserves by 1/10.
Now this could cause another normally higher price commodity to be substituted after a large expenditure for start up. All the incompetent state company would have to do is wait till the start up money is spent then turn their valves to the left increase production to a rate and undercutting the start-up. Once the competition is out of business then turn the valves to the right and watch the price jump back up. (See 1980's with all the money that was spent for enhanced recovery of oil that went down the tubes when the price bottomed out).
Posted by: rob at May 13, 2008 9:04:48 AM
National oil companies have a very different set of priorities to those of the private companies. And the NOCs control about 90% of world oil production.
I think the repeated call that oil is in a "bubble" or that "speculators are messing up the market" is to provide for some illusion that prices will drop. As well as to provide an excuse for why all these magical solutions like, oh, "shale oil" or "tar sands" aren't springing into production.
Posted by: Tangurena at May 13, 2008 9:24:47 AM
I am usually alarmed when a major investment bank is very public about oil soon reaching $200 per barrel. This is especially the case when said companies are now able to invest in oil at margins far below what they are able to invest in stocks, for example.
Typical oil contracts are for 1,000 barrels. Depending on whether you are a member of the exchange or not, intial margins are $8,775 (per contract) for a non-member and $7,150 for a member. The maintenance margin is $6,500 for both.
These are for one contract of nymex WTI. It's a bit more for nymex heating oil and nymex gasoline. The margin for an ICE WTI contract is $7,000 (only maintenance, no initial).
The point being that the margin isn’t very much if oil is, say, $115 a barrel ($115,000) and margin is at most $15,275 (around a 15 pct margin). However, contracts are marked to market daily, and I could see financiers of positions becoming nervous if the price were falling and you were long or if prices were rising and you were short.
Perhaps there is nothing wrong with the oil market that a good 50% margin requirement wouldn’t cure.
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Posted by: wintercow20 at May 13, 2008 9:31:15 AM
To Michael Webster:
Certainly, a distinction can be drawn between "real scarcity" and what you call an expanded concept of hoarding. That distinction is obvious right now, as investment flows into more expensive means of production (oil sands, shale, CTL technologies, deepwater, steam-injection enhanced recovery in marginal fields, etc.) are far slower than one might expect with barrel prices at $125.
The problem is that speculators, or NOCs indulging in surreptititious speculation through production foot-dragging, have an excellent point. Demand growth in enormous developing economies, as well as a security premium dictated by political instability in key producing regions, suggest that the price of oil has not yet found its zenith. It will be difficult to know when exactly that zenith is imminent, but it is not hard to know that it is not imminent yet. Add to this the lengthy lead-time of capital investment in production (especially the more exotic and expensive models), and you have a situation where extremely high upside potential will be required to offset extremely high perceived risk.
Bottom line: it may be a bubble, but if it is, it has a lot more inflating to do before it does anything else.
Posted by: Robert Heiler at May 13, 2008 9:56:30 AM
I need some new terminology, (which I'm sure has already been invented) for the "game of chicken" aspect of certain bubbles. Certainly in Tech Stocks circa 1999 or housing circa 2005, there were people who willfully decided to get into the game of chicken, buying just to sell to another chicken player.
If there were a measure of this behavior, I think it would prove predictive of drastic future price declines.
When people report that X% of all houses purchased were purchased with the intent of resale within 1 year, and 0.9*X% of such houses are bought by others with the same intentions, we ought to be able to make some predictions about how long this will last.
So, what are the relevant measures of intentions of people buying commodities?
Posted by: jim at May 13, 2008 10:28:56 AM
Aren't these contracts cash settlement anyway with OPEC following the price set in the futures market? that way there's no need for taking delivery and needing to store what you buy..
Posted by: Duff Samoa at May 13, 2008 10:38:24 AM
I think you're off on a couple counts. First, most of the state oil companies are quite competent. Yes, there are cases where the state companies lack certain specific skills, e.g. PEMEX in ultradeep water, but I believe these are not the only or even a major cause of the high prices.
Second, for the most part, increasing production is not simply a case of opening a few valves and backing up the tankers. You want another 100,000 barrels per day? Great, it's going to cost $10B, take 5 years to design and build the capacity, and by the way, there is a shortage of drill rigs and technical resources available in the world today, so help may not be available at any price in that 5 year timeframe.
Capacity to produce oil is becoming ever more expensive, which moves the supply curve up.
Fundamentally, there is an inelastic short term supply and demand curve, which causes oil prices to swing wildly. When the prices collapse, it won't be because there was a bubble, it will be because, as has always happened, demand was temporarily less than available supply.
My guess is that it will be a short-lived spell of low prices before demand once again drives prices up.
The other factor in play is the weakness of the US dollar, which has driven the price up for American consumers. I'm sure someone has done the analysis of that impact.
Tony
Posted by: Tony K at May 13, 2008 10:52:10 AM
"We have lots of state-owned oil companies and maybe their way of speculating is simply to remain sluggish in their exploration and extraction activities(...)". This actually happened in Brazil in the 70's, for ideological purposes though. Giuseppe Bacoccoli, who worked for 32 years on the exploration area of Petrobras - the brazilian state-owned oil company - has been saying that when the company knew there was a place with no probability of having oil, it auctioned it for the private sector. So, doing this, the sate would have the monopoly of exploration and would also earn some money from the auciotns.
Posted by: Felipe Araújo at May 13, 2008 10:59:56 AM
"Aren't these contracts cash settlement anyway with OPEC following the price set in the futures market? that way there's no need for taking delivery and needing to store what you buy.."
No, Oil contracts on NYMEX have the option of delivery so there is a direct link between the spot and futures at expiry.
I think what Krugman is aiming at is the idea that the Oil price is in a bubble due to financial market speculators not NOCs. And I agree with him. The spot price of oil is high not just the futures the only way financial speculators could be to blame for this is if they were buying spot and storing the oil for future delivery.
To the idea of raising margins on NYMEX contracts. I serioulsly doubt that would do anything. First off Oil is a world market so trading could easily move to the Brent futures contract traded in londo. Second, margins would have no affect on the Cash market which is also high. Third, the price of Natural Gas futures would probably RISE in response, Non-comercials "speculators" are net short natural gas (at least they were a weak ago when I looked at the commitment of traders report). People forget that speculators influence the price in BOTH directions.
Posted by: eccdogg at May 13, 2008 11:07:24 AM
Superimpose the NASDAQ index over the crude oil price, with NASDAQ in March 2000 coinciding with oil
in April 2008. There is a 92% correlation. Do all bubbles look alike? The NASDAQ bubble had
nothing to do with inventories of pets.com, so why do need inventories of oil to explain a bubble?
Oil is an asset as well as a consumption good (like housing that way). Its price can rise if
future supply and demand prospects suggest that future prices will be so high that it pays to buy rights
to oil now. (Hotelling and all that.)
It is odd that Krugman is obsessed with inventories. Some years ago, he presented a model of OPEC with
multiple equilibria: a high price and low price equilibria, made possible by a backward bending supply
curve. The supply curve turns backward for a while because as prices rise, oil exporters want to
invest more, and they invest by keeping oil in the ground. Put another way, they are targeting total
revenue, not profits. So, as you said, one way to build inventories, consistent with the old but not new
Krugman, is to pump less oil.
Posted by: B.H. at May 13, 2008 11:07:44 AM
Krugman is right and Tyler is confusing (maybe not confused). The speculative bubble argument is that prices rise because of the demand from speculators. But for this to cause prices to rise the oil they buy must be removed from the market; this we do not see. Oil is produced and consumed. The speculators do not consume it.They do not keep it in ther closet, so it has to come back to the market eventually. Hence, they cannot drive the price up unless they keep diverting oil to their own strategic oil reserve. If OPEC produces less oil because they want a higher price that is cartel behavior. It is not a bubble. Increased scarcity drives up the price. If there was no OPEC price would be much lower anyway, since they restrict investment in reserves in their countries. Why? To keep the price high.
Posted by: Barry Ickes at May 13, 2008 11:13:07 AM
"The NASDAQ bubble had
nothing to do with inventories of pets.com, so why do need inventories of oil to explain a bubble?"
Because there is a cash to futures relationship for Oil, you can deliver actual Crude Oil against a futures contract for Oil. And the cash market is ruled by fundamentals the price is set at where the market clears supply and demand. There is no such relationship for Pets.com
Posted by: eccdogg at May 13, 2008 11:30:59 AM
>>>As well as to provide an excuse for why all these magical solutions like, oh, "shale oil" or "tar sands" aren't springing into production.<<<
From Wikipedia (http://en.wikipedia.org/wiki/Athabasca_Oil_Sands):
"...2005 production of crude bitumen in the Athabasca oil sands was 760,000 bbl/d...
...As of 2006, output of oil sands production had increased to 1.126 million barrels per day (179,000 m³/d) (bbl/d). Oil sands were the source of 62% of Alberta's total oil production and 47% of all oil produced in Canada...
...With planned projects coming on stream, by 2010 oil sands production is projected to reach 2 million barrels per day (320,000 m³/d) or about two thirds of Canadian production."
Posted by: Thelonious_Nick at May 13, 2008 12:30:48 PM
More likely a case of extreme competence. Produce more and see profits fall or produce less and make it up in price. Particularly when you are already making more money than you know what to do with. Investing in future inventory may be the best investment they can make, and likely is.
Posted by: Lord at May 13, 2008 1:19:43 PM
Wow. It's a little disconcerting to see Krugman write something I've thought.
Recently, I tried to convince my self that I must be wrong (thanks to Paul, I now have more reason to think I must be wrong), that speculation from instability can drive up prices. But I kept hitting that wall that it can only do so if people increase their ability to store. In addition to storing it in the ground, I've also heard that we're increasing our reserves and Iran is building giant barges to store oil in for future delivery.
Posted by: aaron at May 13, 2008 2:07:11 PM
Certainly the so-called Big Oil companies of the west were better at the pursuit of yearly and quarterly growth (sales and earnings). Just look at their fields - most boomed and are in decline now. The NOCs lurch from good production to weak production and thus over the longer term their production can seem much flatter.
I think we have seen a paradigm shift. There are two ways to make profit as an oil producer - pump-more/sell-more and raise-the-prices.
The paradigm shift is that there is now no player in the market with enough serious excess capacity to bring the market to surplus and those reputed to have "some" excess capacity realize that restraint will make them a lot of money.
Thus OPEC has lost one of its two teeth - flood the market to reduce prices.
They can still hold back product.
Perhaps this is even worldwide collusion. Perhaps it is the more subtle signaling. The crude oil producers all just signaled to each other by all the talk of "the easy oil has been found" only difficult oil remains to be found...
and they all picked up on the tune...
Certainly oil sands and tars in Canada and Venezuela are more expensive to produce than other types of crude oil. If some supplier could flood the market they could drive these operations perhaps to bankruptcy. Deep water drilling (like Jack 2 in the Gulf of Mexico) is also very expensive.
So at this point which producer would venture to bring the prices down?
Or perhaps this is about as much as we will ever be pumping on a daily basis and everybody's hands are tied. Certainly if you look at the data most of the growth these past couple years has been biofuels and the capture and selling of the heavy gases known as NGL - Natural Gas Liquids. [ethane, propane and butane]
Posted by: JRip at May 13, 2008 2:24:08 PM
The dichotomy Krugman and others make between a presumably inefficient "bubble" caused by "speculation" and fundamental (geological and technological) scarcity presents a false choice.
The more likely alternative is that the parallel price rises of practically all commodities (not just oil) are a rational and socially efficient response to the inflation (M3 etc.) of the dollar and to a lesser extent of the euro. The vast increase in "non-commercial" or "speculative" participation in commodity futures reflects a greatly increased use of commodities over the last 5 years for their monetary qualities, just as Carl Menger and others would predict. See Commodity Derivatives: the New Currencies and The "Hoarding" and "Speculation" in Commodities.
Posted by: nick at May 13, 2008 2:40:42 PM
No discussion of the possibility that we may be running out of the easy-to-find, easy-to-drill oil?
@Nick: Oil sands are a little silly. Physically, what they're getting now is the most available -- its the part fo the seam that is above ground. If they want to continue producing, they will need to follow the seam underground, which will obviously entail more cost. Add to that the fact that this process consumes enormous amounts of water and natural gas, and this looks worse all the time.
In terms of production, if these optimistic predictions bear out, Canadian oil sands will provide roughly 3% of world needs. It's not clear that the oil sands are now net energy positive, and less so that they will be in the future (when they have to dig deeper into the ground to follow the oil sand seam). More on oils ands here: http://www.theoildrum.com/node/2915
Finally, in the meantime, lots of other oil sources are drying up: http://www.hubbertpeak.com/nations/2004
I now that "peak oil" isn't a popular phrase in these parts, and I personally believe we won't end up in a Kunstlerian nightmare (http://www.energybulletin.net/4856.html) -- but if we keep ignoring the problem, we might.
Posted by: Doug Blair at May 13, 2008 3:22:19 PM
A speculative bubble is when people are buying an asset because the price is rising. Not because there are some underlying fundamentals pushing the value up, but simply because they believe they can sell it tomorrow for more than they paid for it today. This is what happened in the 20s with stocks, what happened in the 90s with internet stocks in particular, and just recently with housing.
I don't think oil fits this at all.
Posted by: Noah Yetter at May 13, 2008 4:22:12 PM
PDVSA , venezuelan state owned company, fired 20,000 workers in 2002.2/3 of their workforce.The production fell to less tan 2 m b/day.Know its said they have 100.000 workers.Exreme competence.Read the mexican newspaper or see mexican tv and you will know about the exteme competence of Pemex in briberies , corruption and waste
Posted by: k at May 13, 2008 4:50:18 PM
venezuelan state owned company, fired 20,000 workers in 2002.2/3 of their workforce.The production fell to less tan 2 m b/day.
This was a quite rational thing for Venezuala and other oil producers to do in response to rising supplies of dollars and euros, as central banks focused their efforts on combatting first the dot-com crash and now the real estate crash. The oil in the ground is now worth far more than the dollars or euros they would have gotten for it. As long as owners of oil reserves can rationally expect central banks to keep inflating (and there is good reason to expect they will, for example because Ben Bernanke is now replaying the monetary methods of John Law), they profit from keeping oil in the ground and lose from investing money to pump it.
Posted by: nick at May 13, 2008 5:07:04 PM
http://www.nytimes.com/2008/05/14/business/14oil.html?_r=1&hp&oref=slogin
well there's your hoarding...
Posted by: Eugene at May 13, 2008 5:27:31 PM
I agree with Barry Eckles that Krugman is right and T is a bit confusing here. It's clear that there has been an outward shift in the demand curve due to accelerating growth in China and other developing nations. The supply situation seems more complicated to me. Oil production can be modelled as a real option. Maybe its true that some of the national oil companies aren't good at figuring out when to exercise their options to explore more, drill more, or pump more. But history suggests that the incompetent and/or corrupt state oil authorities are much more likely to err on the side of pumping too much rather than too little when prices spike upward like they have recently.
Posted by: Pat L at May 13, 2008 8:15:27 PM
Pat L:It's clear that there has been an outward shift in the demand curve due to accelerating growth in China and other developing nations.
Do you have good evidence for this, or are you just repeating what many others have been repeating? The most credible sources I've read say that demand has not departed from its long-term global trend: higher demand growth for commodities including oil in Asia has been offset by lower demand growth for commodities including oil in the U.S. and Europe.
Posted by: tasmania at May 13, 2008 8:41:27 PM
