The 2008 Oil Price "Bubble"

As oil prices began to rise in 2009 from a low point of about
$40 a barrel in January to around $70 a barrel in July, a key
question is whether the world is in for another oil price spike
in the near term similar to that witnessed in early 2008. Several
hypotheses were advanced when world oil prices started their
inexorable climb from 2003–04 onwards, then skyrocketed
from $92 a barrel in January 2008 to cross the $140 a barrel
mark in June, finally hitting a record high of $147 a barrel
on July 11, 2008, before collapsing to less than $40 a barrel in December.
There was the “peak oil” explanation,
based on the theories of M. King Hubbert of “Hubbert’s
Peak” fame and his supporters, notably Colin Campbell and
Matthew Simmons, that the world was running out of oil.
There were the market “fundamentalists,” including importantly
John Lipsky, the first deputy managing director of the
International Monetary Fund (IMF), and Philip Verleger, a
well-known oil expert, who argued that the fundamentals
of demand and supply were primarily behind the extraordinary
rise in oil prices in the first half of 2008. Interestingly, this fundamentals
view was also shared by the US Treasury and was articulated
by David McCormick, then undersecretary for international
affairs, in a presentation in July 2008 at the Peterson Institute
for International Economics. Finally, there were those who
maintained that such an increase could only be a “bubble,”
unexplained by peak oil theory or market fundamentals.

Many financial-market participants were proponents of this
third view, notably Michael Masters (2008), as well as the
main oil producers, who were as surprised as anyone at the
speed and size of the price increase over only a few months.
Their argument was that the phenomenal increase in financialization
of commodity markets during 2006–08, including in
particular the oil market, led to speculation and momentum
trading, which pushed oil prices way beyond their long-term
equilibrium level as determined by fundamentals.

…While market fundamentals obviously played a role in the general
run-up in the oil prices from 2003 on, it is fair to conclude by
looking at a variety of indicators that speculation drove an oil
price bubble in the first half of 2008. Absent speculative activities,
the oil price would probably have been in the $80 to $90 a
barrel range. What, then, does the 2008 phenomenon imply
for the future? If the market valuations indicator returns to
trend, then a price of $80 to $90 a barrel is clearly in the cards.
In fact, spot prices are already around $70 a barrel and appear
to be climbing back to their 2008 equilibrium level of $80 to
$90 a barrel, so that day may be fast approaching. Indeed, some
forecasters, such as Goldman Sachs, are already revising their
projections significantly upward for 2010–11, generally in the
$90 to $100 a barrel range, which would be somewhat above
the equilibrium price as defined here.

The key question is whether another oil price bubble is
likely in the future. Naturally, one cannot predict bubbles,
as by definition we don’t know what causes them in the fi rst
place. But it is clear that there will be upward pressure on oil
prices in the next year or so as the world emerges from recession,
demand for oil picks up again, and inventories fall back
to their average or normal levels. Whether this will turn into
a 2008-type bubble depends on the degree of speculation in the oil market. If, as argued in this policy brief, speculation
played a significant role in the 2008 bubble, then something
will need to be done to control it to prevent the emergence of
another bubble in the future. The policies being considered by
the CFTC (2009) to put aggregate position limits on futures
contracts and to increase the transparency of futures markets
are moves in the right direction.

A longer-run danger for the world economy, independent of the speculation argument, is that oil capacity expansion has slowed in 2009, and both national and multinational oil companies are postponing plans to develop new fields and expand existing ones. Even though there is currently a serious push for greater fuel economy and development of alternative sources of energy, it is unlikely that these new technologies will make a significant dent in the demand for oil over the next few years. The International Energy Agency, for example, based on IMF projections of world growth, forecasts world demand for oil to rise by about 0.6 percent a year from 2010 on, reaching 89 mbd by 2014. If supply does not keep up and provide the additional 3 mbd needed by 2014, a serious imbalance between future demand and supply in the world oil market would emerge. A major joint effort on the part of both producers and consumers to correct this potential imbalance, possibly along the lines proposed by Prime Minister Brown and President Sarkozy, involving both capacity expansion and conservation, will be needed over the next few years. Absent such an agreement, and if there is no brake to speculation, a repeat of 2008 could easily occur with spot oil prices soaring above their long-term equilibrium level. Whether this is a high-probability scenario or only a “tail” risk is a matter of judgment, but the signs are there. Unless appropriate policy actions are taken to bring the oil market into long-term balance, and to limit speculation, it may well be that the $147 a barrel hit in 2008 was not just a once-in-a-lifetime event but rather a harbinger of things to come.

Peterson Institute for International Economics [PDF]