Is There an Oil Price Bubble?

I’m not sure exactly what a “bubble” is. The popular view is that a “bubble” exists when the fundamental value of an asset (the present value of the stream of cash flows that one might expect to receive in the future) deviates significantly from the market price of that asset. But future cash flows are by definition uncertain. Because market fundamentals are based on expectations regarding future events, I don’t know how one can know a priori when a bubble exists unless one has access to a time machine or crystal ball. There are plenty of citations I could offer (like this paper from the Federal Reserve Bank of New York and this paper from Brookings) from very credible economists arguing that the rise in housing prices was perfectly consistent with “non-bubble” economic fundamentals.

Moreover, “bubbles” (that is, market expectations regarding future returns that turn out to be incorrect) can last a long time. Economist Robert Shiller, for instance, analyzed approximately 400 years worth of housing data and concluded that, over time, housing prices track increases in income. But housing markets can – and have – deviated markedly from that fundamental price trajectory for as many as 50 years before reversion to the mean.

Two questions naturally arise. First, is a 50-year bubble really a bubble? Second, are investors irrational (or engaged in irrational speculation) if they invest based on solid data regarding returns from a multi-decadal economic trend? It may be perfectly rational to invest in an over-valued asset if one has good reason to think that one can take the profits and run before the bubble bursts. And it may be perfectly rational to believe that market fundamentals have changed so much that 50 year-old data is no longer relevant to the market at present or future.

I am unsure whether we’re witnessing a bubble in oil markets today. Two “non-bubble” explanations for the price run, after all, are perfectly plausible. First, it may very well be that low-cost crude is running low and/or that demand will continue to surge to such an extent that prices have nowhere to go but up. Second, OPEC member states may continue to invest modestly in upstream capacity in order to maximize revenues, so even if there is plenty of low-cost oil still available in the world, the cartel will prevent new supply from reaching the market. For the record, I am skeptical of both propositions, but I do not dismiss them out of hand.

The initial driver for the oil price increases we’ve seen since 2003 appears clear to me. A combination of tight production capacity and a surge in demand provided the foundation for the current price run. The oil market moves in rather predictable boom and bust cycles, and historic market patterns foretold the timing of this event if anyone was paying attention. For that trend data, see chapter 3 in this book by my colleague Peter VanDoren.

The best argument against “speculation” in the subsequent price spiral is offered by oil economist Phil Verleger, a fellow I think quite highly of. Verleger believes that, whatever truth there might be to the simple “supply-and-demand” story I offered above, those price increases were greatly exacerbated by a huge move of dollars into commodity futures. That influx of cash was not driven by speculation (classically defined). According to Verleger, it was driven instead by the market recognition of the fact that, historically speaking, (i) commodities provided better returns over long periods of time than provided by equities, and (ii) returns on commodity investments are negatively correlated with returns on equities.

Hence, market actors thought they found an investment vehicle that provided a hedge against volatility in stock markets while also promising excellent long-term returns to boot. Even more interesting for our purposes, however, is the fact that this huge flow of cash into commodity futures (with a very large share of that investment going to oil and gas) came primarily from large institutional investors such as pension funds, university endowments, and the like. Those investments tended to be fully collateralized (that is, institutional investors were not borrowing to invest) and they are buy-and-hold investments for the long term. Neither of those two investment strategies is consistent with the popular vision of what constitutes “speculation.”

The most recent Fed actions to combat the deteriorating state of the macroeconomy added even more fuel to the oil price fire. With market actors increasingly convinced that the Fed is willing to entertain inflation in the course of injecting liquidity into the market, investors are looking for investments to hedge against inflation. And what do you know? Returns on commodities have historically been better during inflationary periods than during non-inflationary periods. Ben Bernanke thus sent another strong infusion of cash into commodity futures – again, largely into oil and gas futures.

The increased demand for oil futures drives spot prices because it diverts oil from immediate use into inventories. The stepped-up infusion of oil into public inventories (the Strategic Petroleum Reserve and the emerging state inventory maintained by the Chinese government, for instance) has also contributed to the diversion of oil from immediate use and thus, has further increased prices. Federal mandates for low-sulfur fuel hasn’t helped either.

For what it’s worth, Verleger does not believe that this infusion of cash into oil futures is sustainable. Returns have been modest and there are simply not enough profits available to support these investments over the long haul. “Speculators” – classically understood – have reacted and will continue to react by leaving the market when returns prove disappointing.

Large institutional investors, however, are less sensitive to changing price signals given their “buy-and-hold” strategy and relative lack of market sophistication. But sooner or later, Verleger thinks that they, too, will take much of their cash out of the commodity markets. Historically correct observations about past returns in commodity markets will not hold. They reflect observations about a market that was absolutely tiny compared to the size of the present commodity market (inflated as it is with institutional cash) and profits have and will be dissipated.

Verleger goes so far as to put the “bubble” tag on oil markets, but again, he does not attribute that bubble to simple speculation. Nevertheless, he predicts a (big-time) crash, but does not predict when that crash will occur. I am less certain about the “bubble” tag (see my introductory paragraph), but I wouldn’t bet against it. I think Verleger’s narrative regarding the root causes of the oil price boom is better than any other I’ve run across.