In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Monday, May 26, 2008

The Oil Speculation Debate

by Calculated Risk on 5/26/2008 12:39:00 PM

Real Time Economics at the WSJ has a nice summary today: Oil Bubble? The Debate Rages

For reference, here is Justin Lahart's article today: Commodity Prices Soar, But Are They in a Bubble?, and Professor Hamilton has a new research paper on the subject that covers all the key issues: Understanding crude oil prices

First, what is a bubble? Back when I was arguing there was a bubble in housing, I wrote: Housing: Speculation is the Key

A bubble requires both overvaluation based on fundamentals and speculation. It is natural to focus on an asset’s fundamental value, but the real key for detecting a bubble is speculation ...
From Real Time Economics:
It is far from clear that the first part of the bubble definition — prices in excess of their fundamental value — is in place. But the second part — that people are buying in anticipation of selling at a higher price — certainly is.
I'm not so sure. Speculation requires storage - something that was obvious in the housing bubble, but isn't so obvious for oil.

From Real Time Economics:
Harvard’s Jeffrey Frankel, has argued for the idea that speculation is behind the run-up in price. He says that such behavior is due to the sharp reduction in interest rates by the U.S. Federal Reserve. Low rates encourage commodity stockpiling, he says, by making it less attractive to sell commodities and put the proceeds into bonds and other debt instruments.

Critics of Mr. Frankel’s theory, including Paul Krugman, say the expected rise in commodity inventories hasn’t shown up.

Mr. Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground.
Frankel's argument is similar to the one I suggested here (based on research from Professor Krugman!): Petroleum Prices and GCC Spending.
[T]here is a possibility that what has looked like peak oil to some observers (something I believe is coming), was actually GCC countries investing by not extracting oil. If oil prices start to fall, and with rising expenditures, the GCC countries might increase production - causing prices to fall further.
So is oil a bubble? Is there evidence of speculation and storage? Some people have cited recent comments by Saudi Arabia's King Abdullah as evidence of storage, from Reuters: Saudi King says keeping some oil finds for future
"I keep no secret from you that when there were some new finds, I told them, 'no, leave it in the ground, with grace from god, our children need it'."
I'm skeptical of this comment (and similar comments from Saudi officials over the years), because I think it is intended for domestic purposes.

The alternative to speculation is that oil prices being driven by the fundamentals of supply and demand - with strong growth in global demand, even as demand weakens in the U.S. - and suppliers are struggling to keep up.

On supply, from the WSJ: Energy Watchdog Warns Of Oil-Production Crunch
The Paris-based International Energy Agency is in the middle of its first attempt to comprehensively assess the condition of the world's top 400 oil fields. Its findings won't be released until November, but the bottom line is already clear: Future crude supplies could be far tighter than previously thought.
For several years, the IEA has predicted that supplies of crude and other liquid fuels will arc gently upward to keep pace with rising demand, topping 116 million barrels a day by 2030, up from around 87 million barrels a day currently. Now, the agency is worried that aging oil fields and diminished investment mean that companies could struggle to surpass 100 million barrels a day over the next two decades.

The decision to rigorously survey supply -- instead of just demand, as in the past -- reflects an increasing fear within the agency and elsewhere that oil-producing regions aren't on track to meet future needs.
Oil prices aren't an obvious bubble like housing or tech stocks. It seems the key question is: Are the oil exporting countries producing as much as possible - or are they investing by cutting oil extraction (and leaving the oil in the ground)? The lack of transparency for the GCC countries, and several other oil producing countries, makes it unclear.