Why the Oil Price Rise Is (Probably) Not a Bubble

I've suspected for a while that we were in a speculative bubble with respect to oil prices.  Paul Krugman offers a good insight into the question.  (When he's not preoccupied with left-wing rants, he's a pretty good economist.)  He says (full article here):

... there are only two things you can do with the world’s oil production: consume it, or store it.

If the price is above the level at which the demand from end-users is equal to production, there’s an excess supply — and that supply has to be going into inventories. End of story. If oil isn’t building up in inventories, there can’t be a bubble in the spot price.

So I looked into oil inventories:

We don't seem to have much increase in inventories.  Maybe it's building up outside of OECD countries, where we don't have good data, but if I were going to store millions of dollars of oil in some tank farm, I'd want it in a stable country with secure property rights.  So the oil is probably not hidden in Somalia or Zimbabwe.

What about futures markets?  Let's say that we are in equilibrium (current supply equals current demand) and then speculators bid up the price of oil in futures markets.  If today's spot price does not rise, then I can buy a barrel of oil today, store it for a few months, and deliver it to fulfill my futures contract.  This arbitrage will bid up today's price.  But if today's  price is bid up by speculators in the futures market, we end up with more supply and less demand--which means inventories have to build up.

Think about past bubbles.  In the housing bubble, the inventory of vacant houses, condos and apartments rose (as I've noted frequently in this blog).  In the tech bubble, the inventory of shares of stock mushroomed.  In the tulip bubble, people hoarded tulips for investment purposes (I think).

Tyler Cowen over at Marginal Revolution notes that inventories could be building up underground, as producers choose to not maximize their current pumping.  Seems unlikely, though possible, to me.

So the high prices are most likely due to strong demand and long time lags in exploration and development.

Comments

[Laurence Hunt]

Also think about the "twilight in the Desert" thesis. regardless of what you think of peak oil. If there isn't as much supply there as claimed, then supply trumps exploration skills.

If there isn't enough oil to support our lifestyle, then supply become inelastic. Demand will then match, but at higher prices.

Strategically, I'm expecting lower prices for many reasons, but only transiently.

As a Canadian, it is worth remembering that the Chinese have a millionaire for every Canadian citizen. These particular Chinese consumers are not price sensitive, and they can certainly levy up more for a litre of gasoline than the average Canadian can.

[Michelle Rand]

Laurence Hunt has a good point: for every millionaire in China, there is an ordinary (Canadian, or insert your country of choice) citizen. Considering the oil demand/supply equation from a macro perspective, various short term impacts are inevitable:

1) A new underclass will be created. These will be folks who may be been middle class participants in various economies but who are dependent on low oil prices. Read: the citizen of AnyCountry who cannot compete economically with the Chinese millionaire.
2) The auto, and air travel, will at least temporarily move towards the luxury goods spectrum of the consumer market.
3) Oil prices will surpass everyone's expectation on the upside. The highest price so far is Gazprom's $250 per barrel by mid '09; that is too low. Five dollars per gallon in the US will be surpassed before summer is out.

In China and India, gasoline prices are currently subsidized, to varying degrees, offering no incentive to rein in consumption. There is also no institutional memory in those countries of $1 per gallon gasoline. China puts 1000 cars on the road every day, and those drivers begin with the notion of paying a (subsidized) $3 per gallon price. It's in their budget. If it's not in yours, that's going to be a problem.