Monday, May 12, 2008

Bubble or No Bubble

The controversy over the influence of speculation on oil prices is gaining momentum, spurring congressional hearings and a steady patter of op-eds, including Paul Krugman's column in today's New York Times. The idea that oil prices have been artificially elevated beyond a realistic, market-clearing level is of interest to more than just consumers. Biofuel producers have so far failed to reap the bonanza from high oil prices that they must have expected, because of steady increases in the price of grain, oilseeds and other inputs. A sudden oil-price collapse back to $60 or less could do many of them in, particularly with large increments of new capacity coming on later this year. Gauging the future price of their principal competition has become more challenging than ever, when the futures market has proved such an unreliable source of predictions.

Professor Krugman makes a solid argument that today's high oil prices exhibit few of the signs of past speculative bubbles, especially in regard to the level of oil inventories around the world. They don't reflect the degree of hoarding that would be expected, as speculators stored oil in anticipation of selling it at a higher price later. But while I agree with Dr. Krugman that assertions of an oil bubble going back several years owed a lot to wishful thinking, I wonder if he underestimates the influence of an oil futures market that didn't even exist during the energy crisis of the 1970s. This goes beyond the simple notion that a large, liquid market in oil futures allows investors to speculate on the future price of oil without having to take possession of it, and at a much lower carrying cost than if they had to pay for it all and lease a tank in which to store it. The connections between the physical market and futures market have become pervasive, and they tend to reinforce the upward pressure on prices from rising global demand and restrictions on access to resources.

Last December the noted oil expert Philip Verleger testified on oil prices before a joint hearing of two Senate committees. As part of his compelling argument concerning the disproportionate impact of the government's policy of putting additional sweet crude oil into the Strategic Petroleum Reserve, he described how a relatively obscure technique called "delta hedging" could reinforce an upward trend in the futures market. He used the example of Southwest Airlines buying call options on crude oil at a strike price of $51/bbl. through 2009. As the price of oil increased, the financial firms that sold these options to Southwest would have had to purchase increasing quantities of oil futures contracts, in order to manage their exposure, as the options got ever deeper "in the money." The higher the price of oil goes, the more oil futures the call option seller must buy to stay neutral, in a classic positive reinforcing loop pushing up the demand for oil futures, and thus their price. I wish I had noticed his testimony at the time, because Dr. Verleger accurately foresaw the market move past $100 to $120.

This example offers an important insight for those who are focusing on the role of speculation in oil prices. Rather than viewing speculation as the driver of a bubble along the lines of the Dot Com or recent housing bubbles, it makes more sense to view it as an amplifier inserted into the circuit that runs between the energy futures, options and derivatives markets and the markets for physical oil. As long as demand growth continues in spite of high prices--with modest reductions in US demand offset by growth in countries that insulate their consumers from high market prices--speculation will continue to amplify negative supply news and push the market to new heights. However, if new production or conservation suddenly began to overwhelm demand growth, producing a short-term surplus, that signal would be amplified just as effectively, unraveling speculation at a record pace. The "delta hedging" mechanism described above works in reverse, too.

That doesn't mean that alternative energy firms should be overly concerned that oil prices will drop below $60 per barrel and remain there indefinitely. While oil above $100 per barrel has failed to crush global demand, at least so far, oil below $60 would surely stimulate it. The long-term fundamentals remain strong, as oil heads for an effective ultimate limit on global output--whether that limit is 85 million barrels per day, 100 MBD, or even 120 MBD. It does, however, suggest the need for financial flexibility: balance sheets healthy enough to withstand a few quarters of low or negative margins and weak sales. More importantly the possibility of a temporary oil-price dip should not blind the management of these firms to a much larger emerging threat, the prospect that a perceived global food crisis will unravel support for the government subsidies and mandates that have been the principal engines of the industry's growth for the last two decades.

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