June 21, 2005
The oil-price bubble
It doesn’t seem like two months ago that I wrote this:
In many ways today’s oil market reminds me of the dot-com insanity, what with analysts like Goldman Sachs’ Arjun Murti channeling Henry Blodget, predicting $105-a-barrel “super spikes,” and scaring us all into trading our Hummers.
Not gonna happen: oil prices are going down, not up. Sure, there'll be some ups along with the downs, but a year from now oil prices will be sharply lower than they are today. My (hypothetical) money is on something around $40 a barrel.
Back then, oil was around $55 a barrel. Today it nudged $60, and the mainstream media (along with parts of the blogosphere) seem to think the sky is falling. I expect the superspikers to start talking up $120-a-barrel oil any day now.
Spot oil prices climbed to new highs last week even as the price of the December 2011 futures contract fell, steepening the backwardation I commented on here and here. A look back at what happened in the early 1980’s may give some insights into what the market may be expecting next.
… The short run demand curve [of the petroleum market] is quite inelastic – huge price increases are necessary if you want to cut oil use significantly over the next few months. When, as in the current environment, there is limited excess capacity, supply is quite inelastic as well. The result is that spot oil prices are going to be extremely volatile in response to any disturbances on either the supply or demand side.
Given more time, however, as new vehicles and equipment get replaced, there are lots of things that businesses and consumers can do to reduce oil use. Most of the demand response to today’s high oil prices will not be seen until several years down the road. Whether the price increases so far will be sufficient to restore a longer run stability to oil markets without a global recession is the big question we're all pondering at the moment.
And then, as I wrote in April, there’s the little matter of speculation. The past 2-3 years have seen increasingly vast bets on higher oil prices being made by hedge and pension funds—largely via indexed products developed by companies like superspikers Goldman Sachs. As Victor Shum, energy analyst at Texas-based Purvin & Getz, notes [August 2005: link replaced with new copy]:
“This year we’ve had a confluence of factors driving up this rally: First, more hedge funds are allocating money to the red-hot oil markets; second, demand is outstripping supply; and third, capacity is tight in refineries and OPEC production facilities … The oil market is prone to price spikes because of capacity tightness, and this attracts the speculators, who tend to buy on momentum.”
The size of this speculative premium is open to, uh, speculation. Last summer, when oil was around $45, the industry consensus was $7-8 a barrel. Some more recent estimates put it as high as $17 [August 2005: link dead, no substitute available], which is probably over the top. But very few analysts will quibble with $10.
This is a bubble—and bubbles always burst. For oil to stay at its present level, you really have to believe that there won’t be any demand response to a price that has less to do with economics than with blind faith.
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