The Oil Nonbubble  

Paul Krugman's latest column is on oil prices - he thinks the high oil price is not in a bubble and thinks supply and demand is the main factor driving the price, contrary to the predictions of the National Review and the like (he also quotes Steve Forbes public comments from a few years ago, which were completely at odds with what he was telling people who subscribed to his newsletter).

“The Oil Bubble: Set to Burst?” That was the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse. Ten months later, oil was selling for $70 a barrel. “It’s a huge bubble,” declared Steve Forbes, the publisher, who warned that the coming crash in oil prices would make the popping of the technology bubble “look like a picnic.”

All through oil’s five-year price surge, which has taken it from $25 a barrel to last week’s close above $125, there have been many voices declaring that it’s all a bubble, unsupported by the fundamentals of supply and demand. So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble?

Now, speculators do sometimes push commodity prices far above the level justified by fundamentals. But when that happens, there are telltale signs that just aren’t there in today’s oil market. Imagine what would happen if the oil market were humming along, with supply and demand balanced at a price of $25 a barrel, and a bunch of speculators came in and drove the price up to $100.

Even if this were purely a financial play on the part of the speculators, it would have major consequences in the material world. Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production. As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again — unless someone were willing to buy up the excess and take it off the market.

The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding — an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.

Krugman also has a blog post on why oil isn't gold.

One reference I didn’t end up using in today’s column was this piece in Reason. It declares that “the oil market is coming to resemble the gold market” where “most gold traders don’t even ask the question of how much gold was mined last year or how much spare gold mining capacity there is. ”

I thought that was a useful comparison — because once you look at the numbers, you see how little the oil market resembles the gold market. Here’s the key fact: as nearly as I can tell, private gold stocks — gold held as a store of value and/or for speculation — are equal to about 50 years’ worth of production.

Meanwhile, private stocks of crude oil are equal to about 50 days’ worth of production. Yes, we should also add stocks of refined products; and there may also, as Yves Smith likes to remind us, be some additional unrecorded stocks (in 1979, I remember, everyone was filling their gas tanks as often as possible, adding to the speculative demand); but the fact remains that oil prices are much more closely tied to the flow of production and consumption than gold, or any other good that is mainly held as an asset rather than actually consumed.

Krugman also links to my TOD post on Sydney petrol price sensitvity (I'm obviously becoming semi-respectable as I get older) - Stranded in suburbia - noting maps of US cities would look similar.

The Oil Drum has this nice picture from the Sydney Morning Herald about the percentage of income Sydney area residents will spend on gas — er, petrol — if the price rises substantially. The outer suburbs are, not surprisingly, hard hit.

Maps for US metro areas would presumably look similar.

This is really our big problem: we’ve made long-lasting investments — in infrastructure, in housing, and to some extent in our auto fleet — based on low oil prices. Those past decisions are what make today’s high prices such a big problem. In the long run we can adjust, but in the long run …