Arnold Kling  

Oil Bubble?

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Any time a price increases rapidly, somebody argues that there is a bubble (although I have not heard anyone proclaim a health care bubble). Here is Frank P. Leuffer on oil.


IEA figures for the first half of the year show an increase in world oil demand of 3 million barrels a day against an increase in supply of 3.5 million barrels a day. About 60 percent of the supply increase is coming from OPEC and 40 percent from non-OPEC sources.

Excess supplies are borne out by rising inventories. In the U.S., crude oil inventories increased by 50 million barrels in the first eight months of this year, the second-largest build in history, and oil inventories for the OECD (the Organization for Economic Cooperation and Development, which includes 30 member countries) increased by 83 million barrels in the first seven months of this year.

Recently, the growth in oil demand has begun to slow in response to high prices and slower economic growth. According to the American Petroleum Institute, U.S. oil demand rose only 0.5 percent in August, owing to a fall in gasoline demand. Oil demand through August is up 1.7 percent, compared with growth of 2.9 percent in the second quarter. Demand-growth in August for China, at 10 percent, was less than half the rate estimated for the first half of the year.

It comes down to this: Fundamentally speaking, oil prices should today be in the high-$20-a-barrel range. That’s based on an assessment of supply/demand economics and current inventory levels (adjusted for hurricane effects). Eventually, that barrel price should decline into the low $20s as oil inventories rise. Why the more-than $20-a-barrel difference between where prices are and where they should be? In large part, speculation.


What he is saying is that oil market participants who are accumulating inventories at a price of $50 a barrel are going to wind up selling it for less than $30 a barrel. He could be right, and I hope he is, but I doubt it. The Hotelling argument is that people will hoard inventories only if they expect the price to increase. The market is telling us to expect price increases, albeit slower price increases than what we have observed so far this year.

For Discussion. If you are handy with Black-Scholes, try using option prices to figure out the market's estimate of the probability of oil hitting $30 a barrell in the next six months.



COMMENTS (8 to date)
Mark Bahner writes:

"If you are handy with Black-Scholes, try using option prices to figure out the market's estimate of the probability of oil hitting $30 a barrell in the next six months."

Well, I'm not handy with Black-Scholes, but I will offer a bet to the first three takers:

The price of oil today (October 1, 2004) is about $50 ($49.50). I will bet up to 3 people that the price of oil 1 year from now will be below the current price of $50, adjusting for inflation as measured by the Consumer Price Index. The loser of the bet pays the difference.

In other words, assume inflation as measured by the CPI over the next year is 2%. That would produce an inflation-adjusted price of $51. I bet it will be below that price on October 1, 2005. If it's actually $60, I owe $9. If it's $40, the loser owes me $11.

Further, while losers can drop out of the bet at any time, if I lose, I will continue the bet every year for the next 30 years. In other words, assuming 3% inflation for the following year, the inflation-adjusted price would be $51 * 1.03 = $52.53. If the price is $70, I would owe $17.47. If the price is $40, the loser would owe me $12.53.

The price of oil, adjusted for inflation, will never be higher than it is today, every year for the next 30 years. Call it...Simon's Law. ;-)

Lawrance George Lux writes:

I too lack expertise with Black-Scholes, but have cursory evidence that sweet Crude will drop about $11/barrel to less than $40/barrel starting somewhere around Thankgiving this year. Discussion of this rationale is delicate, concerning China cutting free of the Dollar, Venezula increasing production, and the switch by American refineries to winter fuels. This will not mean savings to American Consumers in the short-run, and so will further depress American fuel consumption. lgl

Bernard Yomtov writes:

Leuffer's argument sounds a little circular to me. By "supply" and "demand" I assume he really means inventories and consumption rates. He seems to be saying that, given the current ratio of consumption to inventory, the price should be something under $30.

But consumption rates are low and inventories high precisely because of high prices. So it looks like he's saying prices should be lower than they are because they're high, or something like that.

jackinnj writes:

they team taught an advanced finance course in 1974 !

if you live in a log-normal world options are helpful. for the rest of us, Stigler and price theory still rule.

spencer writes:

While I tend to agree that oil will be under $50 a year or two from now, there are some problems with the analysis. Oil inventories are up this year, but for over two years they have been drawn down because oil firms feared being caught with
high priced inventories. The best placed to see this is in real oil imports, that were flat from
2000 to 2004. They started surging this year and are back to their long term trend 6% growth rate, and is one reason prices have surged-- US oil imports is the demand curve from OPEC's perspectives.

Finally, the oil I/S ratio is at near record lows
despite the increase in oil inventories. This is the relevant measure to watch, not the actual increase. All the big surge in inventories and imports was simply to offset the prior 3 years of unnatural declines. If you look at it this way the inventory data does not lead to the conclusion reached in this article.

The long run price of oil should be in the $20-$30 range, but not because of current supply - demand factors. $20-$30 is the margin price of oil and is determined by the fact that major new supplies of oil can be brought on line at this price with a 1-2 year lag. The question is how long can the current price stay above the marginal price, and what will do it. Historically, it has been achieved by a recession causing a drop in demand.

P.S. in the 1970s the marginal price of oil was the costs of bring on North Sea and North slope oil.

jackinnj writes:

the "marginal cost" of oil in the U.S. during the regulated era of the 1970's (or should I say prior to the Reagan Revolution) was that attributed to an incremental barrel out of a stripper well.

Paul Cox writes:

If I accept the justification of Mr. Leuffer's argument, that inventories are up, growth in oil demand in the U.S. is affected by price, then as he suggests the price should be in the low $20 range.

What he does not answer, other then attributing the high prices to speculators, is how the speculators are conducting this piece of manipulation, nor why the prices are really at $50.

We should do ourselves a favour and begin to think that the most valuable commodities should be, and maybe are, priced on factors beyond the current inventory. If Mr. Leuffer's facts are correct, then the U.S. has increased their inventories over the past year by 50 million barrels, or approximately 2.5 days of supply at current consumption rates.

Dezakin writes:

I suspect that the oil is above $50 right now on speculation, but the floor isn't much below $45... Demand is growing very fast as 2.5 billion in India and China industrialize very fast, and very few oil producers are actually investing in supply, with memories of the '98 asian financial crisis and OPEC pumping everything they had sending prices to $12 per barrel.

It takes years for new infrastructure to come on line, demand isn't all that flexible, so I'm betting that prices will only go up over the short term and wont come down until the masters of capital decide that oil prices really wont crash under $20 in the next year and decide to drill new wells... And liquefy coal.

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