Oil prices: a big bubble…or maybe not?
By Dr. Kostas Andriosopoulos
The recent run-up in oil price and other energy products between 2003 and 2008, and then their subsequent steep collapse within a few months, to many economists appears to be a huge bubble that was meant to burst (Eckaus, 2008). These developments in the price of oil and in other energy markets have been mainly attributed to the positions taken by financial investors on the futures markets, such as pension funds, hedge funds, investment banks etc. These peculiar dynamics of oil, and most of the energy commodities, have transformed them into financial assets, and as such, they are subject to speculative bubbles.
As Caballero et al. (2008) argue, the financial collapse of 2007 led investors into a search for an alternative asset class that has diversification properties able to deliver positive returns during a market downturn, and they found it in energy commodities and more specifically in oil. According to them, it is this huge inflow of capital towards energy commodities that created this huge rise in oil prices towards the end of 2008, leading to a speculative bubble that burst only a few months later. As Shleifer and Summers (1990) point out, investors' reactions to common signals or their overreaction to recent news can cause herding behaviour. However, in the case of the oil futures markets, Boyd et al. (2009) and Buyuksahin and Harris (2009) conclude that, during recent years, herding among hedge funds did not destabilise the futures markets because of its countercyclical nature. Moreover, in their study on the performance of various hedge funds and commodity fund investment styles during periods of bullish and bearish stock markets, Edwards and Caglayan (2001) find that commodity funds provide greater downside protection than hedge funds do.
There is also a number of researchers and economists that are more sceptic as to whether the oil price spike was a bubble (see Krugman, 2008; Pirrong, 2008; Smith, 2009), basing their argument on the missing stockpiles of oil. In their opinion, betting in higher future prices for oil and energy products, financial speculators would have increased stockpiling where possible. In the absence of stockpiling in oil and other energy products, their argument states that physical markets could not have been affected by speculation in the futures markets. On the other hand, above ground storage and the creation of stockpiles, in the case of energy markets is a very short-term concern as it is a very expensive solution, when it is even physically applicable; only a very low level of inventories relative to total production is maintained at any given time. Based on the assumption of economic equilibrium, Pierru and Babusiaux (2010) take on the view that an increase in oil prices would reduce demand for oil, resulting in any quantity of the non-consumed supply being stored. Based on this economic viewpoint, any accumulation of stocks, even minimal, would imply that the price of oil is driven by speculation above the level set by market fundamentals. As Parsons (2010) states, during the 2003-2008 period no such stockpiling occurred. Adding to the later finding, Hamilton (2009b) argues that crude oil inventories in 2007 and early 2008 were significantly lower than historical levels. Even when investors expect that the long-term price of energy products will remain high, it makes no economic sense for them to increase their production levels in order to store any excesses in facilities above ground until the time of sale. Thus, the argument that the lack of stockpiling should support the belief that the recent increase in energy prices was not a bubble can no longer be considered valid.
Krugman (2008) and Smith (2009) argue that the price spike of 2007-2008 can be attributed purely to supply and demand factors. As Hamilton (2009a, 2009b) and Kilian (2009) suggest, supply and demand fundamentals can explain the recent price spikes, caused by stagnant production and strong demand for energy products, which in turn led the short-term elasticity of oil to historically low levels. During the past decade, there has been a big swift in market fundamentals, mostly caused by strong economic growth in the developing countries like China, India, and Brazil, which was not only rapid but at the same times persistent for a long period of time, increasing demand for oil and other energy products. At the same time, supply of oil and other energy products has been very slow in adapting to the demand, because of falling supply rates from mature and depleted oil fields, and because of the big time lag between new investments in oil and energy production and actual delivery of the projects. Thus, the aforementioned imbalance between supply and demand can be attributed as the major factor for the sharp price increase.
Nevertheless, as sound as the previous argument appears to be, the recent transformation of the paper energy markets due to increased investor appetite for alternative asset classes, which can be very influential, is overlooked. According to Parsons (2010), financial innovations made it possible for paper oil and energy contracts to be considered as a pure financial asset, thus making it very similar to equities in this regard, opening the way for the development of a speculative bubble. Based on data reported by the Bank for International Settlements (BIS, 2009) the notional amounts outstanding and the gross market values of commodity derivative contracts traded over-the-counter, including energy contracts, in mid-2008 were $13 trillion and $2.2 trillion, respectively. A big portion of these funds has been directed into commodities' index funds or index trading, since investors can buy into a commodity index much as they would buy into a mutual fund.
References:
Bank for International Settlements, 2009. Semi-annual OTC Derivatives Statistics At End-June 2008, table 19, www.bis.org/statistics/derstats.htm.
Boyd, N., Buyuksahin, B., Haigh, M.S., Harris, J.H., 2009. The impact of herding on futures prices, CFTC Working Paper.
Buyuksahin, B. and Harris, J.H., 2009. The role of speculators in the crude oil futures market, Working paper.
Caballero, R.J., Farhi, E., Gourinchas, P.O., 2008. Financial crash, commodity prices and global imbalances, Brookings Papers on Economic Activity, Fall, 1-55.
Eckaus, R., 2008. The oil price really is a speculative bubble, MIT Center for Energy and Environmental Policy, Research Working Paper #08-007.
Edwards, F.R., and Caglayan, M.O., 2001. Hedge fund and commodity fund investment styles in bull and bear markets, Journal of Portfolio Management, 27 (4), 97-108.
Hamilton, J.D., 2009a. Understanding crude oil prices, Energy Journal, 30, 179-206.
Hamilton, J.D., 2009b. Causes and consequences of the oil shock of 2007-08. Working Paper, University of California San Diego (March).
Kilian, L., 2009. Not all oil price shocks are alike: Disentangling demand and supply shocks in the crude oil market, American Economic Review, 99 (3), 1053-1069.
Krugman, P., 2008. The oil non-bubble, The New York Times, http://www.nytimes.com/2008/05/12/opinion/12krugman.html.
Parsons, J.E., 2010. Black gold & Fool's gold: Speculation in the oil futures market. Economia, 10 (2), 81-116.
Pierru, A., and Babusiaux, D., 2010. Speculation without oil stockpiling as a signature: a dynamic perspective. OPEC Energy Review, 34 (3-4), 131-148.
Pirrong, C., 2008. Stochastic fundamental volatiltiy, speculation, and commodity storage, Working Paper, University of Houston.
Shleifer, A., Summers, L., 1990. The noise trader approach to finance, The Journal of Economic Perspectives, 4, 19-33.
Smith, J.L., 2009. World oil: market or mayhem? Journal of Economic Perspectives, 23 (3), 145-164.
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