Oil – Is There a Bubble?

There is something puzzling about the price of oil. It is high and rising. I think there are a couple of good reasons why the price is high. First, demand is growing fast (in part because of growing demand from emerging markets), and new discoveries of oil have slowed down. Second, low real interest rates keep the price high. That is standard economic theory. An easy way to understand this is that when the real interest rate is low, producers have less incentive to take oil out of the ground. If they sell the oil today, what will they do with the money they earn? They’ll get a low rate of return, so they might as well keep the oil in the ground and sell it later. This restricts current supply and drives the price up today. Real interest rates have been low for a variety of reasons that have been widely discussed – U.S. monetary policy, a world saving glut, etc.

I can understand why market fundamentals make the price of oil high – but why is it rising? Let me explain this question. Oil is a durable, storable commodity. If the increase in excess demand is expected by the markets, it should be incorporated in the price immediately. That is, if the markets have understood for some time that rising demand from emerging markets was squeezing the market for oil, the price should have jumped immediately to reflect those expectations. If markets expected rising demand four years ago, and could calculate that the price would be $120 today, then the price should have been a lot higher than $40 back then. Anyone who bought a barrel of oil in 2004 would have made a 200% return over those four years. But in anticipation of $120 oil prices in 2008, markets should have bid up the price back in 2004.

Economics is an inexact enough science that we can’t know whether $125, or $60, or $200 is the right price based on fundamentals. I don’t know one way or the other what the right price of oil is, but what I don’t understand is the steady increase in the price of oil. How can an asset such as oil consistently pay such a high return?

Adding to the puzzle is the fact that the futures price has consistently underpredicted the rise in the price of oil over the past several years. If the futures price reflects mostly the market’s anticipation of the future spot price, how is it that the market has been fooled over and over for so many years?

One possible explanation is that the market has kept learning about the strength of demand and the weakness of supply over the years. It is consistently being surprised, in other words. That may be right, but it is a shaky argument: why is the market always being surprised in the same direction – that excess demand is greater than we thought?

Another story that I think makes some sense is the one that Jeffrey Frankel and Jim Hamilton have promoted – that Fed monetary policy has played a role. As I noted at the outset, a drop in real interest rates should cause commodity prices to rise. But here again, the decline would also have to be unanticipated to explain the continual increase in the price.

I think there is a lot of truth to the view that markets keep getting surprised in the direction that makes oil prices higher. We have been surprised at the growth in emerging markets, the shortfall in supply from some countries (such as Iraq), and the continuing low real interest rates. On the other hand, it seems to me that rising prices are also typical of frothy markets (like the housing market of late.) In fact, the steep rate of increase could even be a “rational bubble”. The rate of increase of the price is so high, perhaps, because the market is incorporating a probability of the bubble popping and prices falling back down to earth.

Let me back up and talk about the market for an exhaustible resource such as oil. The amount of oil pumped out of the ground doesn’t just depend on the current price. If I don’t pump the oil today, I can pump it tomorrow. Tomorrow’s price matters, bubble or no bubble.

Let’s start with the market when there is no bubble, and, as economists do, let me make this as simple as possible. Let’s assume there is no uncertainty about how much oil is in the ground, or how much people will want to buy at any price, and no cost of extraction. What should happen then is the expected rate of increase in the real price of oil should equal the real interest rate. Why? If I sell my oil today, I can take the proceeds and get the real interest rate. If I don’t sell my oil, its price goes up at the real interest rate. The incentive to “hoard” is exactly balanced by the incentive to sell, and any individual producer is indifferent between selling now or later.

In this case, there is no excess supply of oil. End users buy as much as they want at the market price, and producers pump out exactly that much. Ultimately the level of the price is determined by the condition that, as the price rises at the rate of interest forever, the sum of demand over the current year and all future years equals the amount in the ground.

Now let me turn the possibility of a “rational” bubble, and now I’m going to use some math. In a rational bubble, the oil price is rising, but there is some probability that the bubble will burst. Let r be the real interest rate. Let p(t) be the log of the real price of oil at year t, pfun(t) be the fundamental long-run price (after the bubble pops), and let k be the probability of the bubble popping. To keep it simple, I’ll assume r and k are constant. Then the expected rate of increase in the real price of oil should equal r:

r = (1-k)(p(t+1)-p(t)) -k(p(t)-pfun(t)).

(For those who aren’t familiar with logs, p(t+1)-p(t) is approximately the percentage increase in the price of oil, and p(t)-pfun(t) is approximately the amount by which oil is “over-priced” in percentage terms. The “expected rate of growth” of the oil price is simply the weighted average of the growth rate of the price if the bubble persists and the percentage decline expected if the bubble bursts. The weights are given by the probability of the bubble persisting or popping.)

So, as long as the bubble has not popped, you will see

p(t+1)-p(t) = [r+k(p(t)-pfun(t))]/(1-k).

The percentage rate of increase in the price exceeds the real interest rate. Indeed, you can see that the growth rate in oil prices would have to rise as the price rose (as p(t)-pfun(t) gets larger.) That is, the price would accelerate until the bubble burst.

In this type of rational bubble, the futures price would indicate an “expected” increase in the price equal to r, the real interest rate. But until the bubble burst, the actual increase in the price would always exceed the real interest rate. So the futures price would always underpredict the actual increase in the price of oil, much like it has in fact over the past four or five years. The payback to speculators betting against oil only comes when the bubble finally bursts.

From the perspective of producers, there is no difference between this and the no-bubble case (assuming that the producers care only about their expected return.) If they “hoard”, they expect the price to rise at the rate r, and if they sell now they can take the proceeds and earn r. They are indifferent between selling now and hoarding. There is no excess supply. Producers pump out of the ground exactly what people will buy at price p(t). The level of the price in this case is determined just as in the no bubble case – the sum of the expected demands in every period equals the amount of oil in the ground.

A bubble in asset prices need not be “rational”. But if the run-up in prices were too rapid, so that the “expected” growth rate of the price exceeded the interest rate, there would be a strong disincentive to sell any oil. Producers would want to keep the oil in the ground, and, as Paul Krugman has argued, speculators would have an incentive to hoard oil. We see very little of that type of behavior going on, as Krugman has noted.

You could make this more complicated by adding uncertainty, risk aversion, cost of pumping, etc., but it wouldn’t change the basic story. Let me note that producers may face some constraints to pumping out as much oil as they would like to at the current high price. But if so, that only means that the current price is temporarily higher than it will be once capacity is increased. That is, it is a reason to think oil prices may fall.

There is some question in the academic economics literature about whether such a bubble as I describe is really rational. This revolves around some esoteric questions of whether there is a “transversality condition” that applies or not. There has been some very complicated modeling of this under different assumptions, but I think in practice it is at least possible that a bubble could exist in a market for an exhaustible resource. There is something of a consensus that we have seen bubbles in other asset prices in the recent past – the dollar in1985, Japanese property prices in the late 1980s, the dot com bubble in the late 1990s, and, perhaps, some U.S. residential real estate markets in the past few years.

The problem for economists is that the market for oil is so complicated that we cannot very accurately calculate what the price of oil “should be” if there is no bubble. We have to read the entrails to figure out whether the price is really reflecting market fundamentals – demand, supply, real interest rates – or has a bubble component. As I look at the rising price, I wonder which story is most plausible: (1) the markets have been surprised over and over about demand by end users and production capabilities; (2) markets have been surprised over and over about how low real interest rates are; (3) there is a bubble. These stories may go together, in fact. Indeed, it is hard to see how a bubble could get started all by itself, or how it could go on for a long time before it popped. In the previous asset price bubbles I mentioned above, it seems as though fundamental economic causes set off the rise in asset prices. But it looks like the bubble traders were inspired by the price increases to bet on further increases in prices, even when there was little evidence that the price needed to rise more based on fundamentals. It’s as if the fundamental traders normally keep the bubble traders at bay. But a series of shocks to the fundamentals in the same direction seem to undermine the confidence of the fundamental traders and give the bubble traders the upper hand. In any case, if either (2) or (3) are true, we might see oil prices coming down in the future, as real interest rates return to more historic levels, or as the bubble bursts.

23 Responses to "Oil – Is There a Bubble?"

  1. Ben Roesch   May 19, 2008 at 12:07 pm

    A Non-Economist’s ThoughtsI see a difference between the 4 recent bubbles and the "oil bubble." There is less of a "completely open market" when it comes to oil. Sure, there is a lot of money to be made by pumping now and selling now, but to most of the owners of oil in the ground it’s money in the bank. You have, in a different way, said something similar by saying that they won’t earn much on the cash they invest.) Don’t these owners have every reason to believe that 10 years from now the price will be higher? Even if there’s a bubble and the price collapses to $50 a barrel (I know that’s not likely) it is just a matter of time – even if it’s a few years – and the price will be even higher than it is now. It’s money in the bank. The owners of the oil in the ground can pump at a very limited rate, make an unexpected fortune at current prices (or even at half the price). I don’t see the incentive, regardless of interest rates, to pump more than the minimum, and the owners of most of the oil can, indeed, control the rate that it comes to market. Thus it is a "cornered market." Only some of the oil is purchaseable by buyers, so the price keeps getting bid up.

  2. Anonymous   May 19, 2008 at 1:30 pm

    Professor Engel, very insightful thoughts and analysis. As an economist in the private sector I appreciate your input

  3. Guest   May 19, 2008 at 1:49 pm

    I don’t understand the real interest rate argument. That seems to view oil left in the ground as an investment.Supppose the real rate of interest is r, and the price of oil left in the ground increases at a rate r.Then r is the nominal rate of return on the investment, not the real rate of return. Isn’t it??

  4. Guest   May 19, 2008 at 2:08 pm

    Sorry. I misread re real price of oil.

  5. j   May 19, 2008 at 3:04 pm

    In the real world, long term optimization of pumping strategies is unheard of. Third world governments are temporary and they are exist in a permanent, urgent, unsatiable need of income. Oil production, therefore, does not react to changes in demand. Price goes up.

  6. Anonymous   May 19, 2008 at 4:45 pm

    The mere fact that so many question whether or not this is a bubble…means it likely is. Regardless of supply, if you raise prices to the point where no one can afford the commodity, you will have a bubble.We’ve heard this all before. During the dot.com bubble, those valuations were justified..blah blah blah….it will crash and likely hard as soon as speculators realize demand is falling through the floor.

  7. Guest   May 19, 2008 at 4:49 pm

    "Second, low real interest rates keep the price high. That is standard economic theory. An easy way to understand this is that when the real interest rate is low, producers have less incentive to take oil out of the ground. If they sell the oil today, what will they do with the money they earn? They’ll get a low rate of return, so they might as well keep the oil in the ground and sell it later."I don’t think oil companies short-term production is influenced by interest rates. I understand this guy is much better at economics than me, but there’s just a couple common sense arguments that seem to disprove this argument. First, oil companies invest the majority of their profits in increasing future production not in standard capital markets where returns are determined by interest rates. Second, around 80% of the world’s oil is controlled by national government rather than corporations. National governments operate differently than economics predicts. Their incentives are different than normal profit motives. They want to keep the oil flowing for as long as possible to provide a continual revenue source for their government. Additionally, a lot of oil profits get invested in public investment (education, infrastructure development, military spending, etc…) rather than interest-rate sensitive capital markets.

  8. Guest   May 19, 2008 at 4:50 pm

    "Second, low real interest rates keep the price high. That is standard economic theory. An easy way to understand this is that when the real interest rate is low, producers have less incentive to take oil out of the ground. If they sell the oil today, what will they do with the money they earn? They’ll get a low rate of return, so they might as well keep the oil in the ground and sell it later."I don’t think oil companies short-term production is influenced by interest rates. I understand this guy is much better at economics than me, but there’s just a couple common sense arguments that seem to disprove this argument. First, oil companies invest the majority of their profits in increasing future production not in standard capital markets where returns are determined by interest rates. Second, around 80% of the world’s oil is controlled by national government rather than corporations. National governments operate differently than economics predicts. Their incentives are different than normal profit motives. They want to keep the oil flowing for as long as possible to provide a continual revenue source for their government. Additionally, a lot of oil profits get invested in public investment (education, infrastructure development, military spending, etc…) rather than interest-rate sensitive capital markets.

  9. Jodie   May 19, 2008 at 7:01 pm

    Unfortunately for those who disagree, the empirical evidence is overwhelming. Whenever, real interest rates turn negative, the price of Oil and all other commodities take off. This shouldn’t be too surprising. When the returns on holding money are negative people will not swap their goods for it.

  10. koteli   May 19, 2008 at 7:12 pm

    Dear Prof. Engel,As I’m not an economist, I’ll take another point of view:First, M. Simmons is tired of saying that oil is dirty cheap, measuring it in cups of whatever liquid. And it’s true.Second, the Big Oil corporations control a little bit less than half of oil output in the world. So, they lost price setting powers a few years ago. Let’s go with some news and try to understand them:http://www.bloomberg.com/apps/news?pid=20601087&sid=ajkO05voC8xU&refer=home"Never have so many oil and gas companies spent so much to produce so little.That’s the challenge facing Exxon Mobil Corp., Royal Dutch Shell Plc, BP Plc, Chevron Corp., Total SA and ConocoPhillips, which will spend a record $98.7 billion this year on exploration and production, Lehman Brothers Holdings Inc. estimates. Costs more than quadrupled since 2000 as explorers targeted more challenging reservoirs and demand rose for labor and material.(…) Drillers could access only 7 percent of known world reserves in 2005, down from 85 percent in 1970 after Middle Eastern nations took control of their fields, according to a July report by the National Petroleum Council in Washington. (…) “What is happening is something different. The international companies are denied access to areas of abundant oil within OPEC, and it’s getting costlier in other areas.”What this says is that oil majors are dying animals, with shrinking access to oil, and skyrocketing costs for those fields they still have access to. Indeed, a big sign of that is that they spend more of their money buying back their own shares (effectively liquidating themselves) rather than investing. Of course, the ever-increasing oil prices allow them to mask these worrying underlying trends under comfortable-looking profits.http://www.bloomberg.com/apps/news?pid=20601087&sid=aB50jeKPl7gE&refer=home"Take away Exxon Mobil Corp., Chevron Corp. and ConocoPhillips and profits at U.S. companies are the worst in at least a decade.Without the $70 billion that oil producers earned in the last two quarters, profits at companies in the Standard & Poor’s 500 Index tumbled 26 percent and 30.2 percent, the biggest decreases for any quarter since Bloomberg started compiling data in 1998.(…) “The oil sector saved the market,” said Dwane. “Ex-oil, the numbers show falling earnings and with data highlighting a U.S. recession, we can expect more earnings downgrades.”(…) Exxon, Chevron and ConocoPhillips, the three largest U.S. producers, all produced less oil in the first quarter. Chevron[‘s] reserves fell to the lowest in almost a decade last year."Interesting combination: lower oil production, exploding production costs and capturing a shrinking fraction of oil profits has not prevented oil companies from enjoying record high profits. And these profits have in turn masked the fact that US corporate profits are otherwise in the doldrums (even excluding the devastated financial sector).So high prices are masking the slow elimination of the oil majors, whose profits are themselves hiding the weakness of the US corporate world.Optimists cling to the notion that this is self-correcting, ie that the recession underway will cause oil demand to shrink and prices to recede, thus allowing all of these phenomenons to go into reverse. But this ignores the fact that demand is already shrinking in the US and Europe. We are no longer driving demand: beyond China, which could be argued to have an economy still to some extent dependent on the health of our own (even though this is highly debatable), it is oil producers like Iran, Saudi Arabia, Russia or others that are enjoying the fastest demand growth – and with current prices (both external, driving their revenues, and internal, driving demand as they are kept very low) this is unlikely to change.With that in mind, you’d expect policy to start focusing on what we can control (ie our demand) rather than to keep on doing little but the all-too familiar – and unwholesome – combination of an arrogant sense of entitlement, casual recourse to raw threats and the most abject begging towards Saudi Arabia et al.But hey, oil profits are flowing, supply-side policies are working!And to finish, I’d like to quote Mr. Bush teaching economics to Arabs:http://news.scotsman.com/latestnews/You39re-running-out-of-oil.4095858.jp"PRESIDENT George Bush yesterday told leaders of the oil- rich states of the Middle East that they must face up to a future without their precious hydrocarbons.In a stark warning, he said their supplies were running out and urged them to reform and diversify their economies. The outgoing United States president told the World Economic Forum, meeting in the Egyptian resort of Sharm el-Sheikh, that it was time to "prepare for the economic changes ahead"."It’s nice to see how sensitive are becoming some people in the USA.–:)Best wishes!

  11. don   May 19, 2008 at 8:14 pm

    "I can understand why market fundamentals make the price of oil high – but why is it rising? Let me explain this question. Oil is a durable, storable commodity. If the increase in excess demand is expected by the markets, it should be incorporated in the price immediately. That is, if the markets have understood for some time that rising demand from emerging markets was squeezing the market for oil, the price should have jumped immediately to reflect those expectations."?? Consider an alternative question. Suppose you suspect, but don’t know, that demand and supply in the future would be such that prices would need to quintiple to reach equilibrium in six years. How fast would you expect the price to move to the new equilibrium? Wouldn’t it seem reasonable to see it move up over a period of time, rather than a one-time jump? Evidence is being provided daily about such things as the ability of the market to absorb higher prices, and the paths of growth in demand and supply of oil. In other words, uncertainty about the future price is declining as time passes. I just don’t see how one can conclude, as the author apparently does, that either the market is being surprised "over and over," or there is a bubble. How fast would the one-time adjustment need to occur to avoid this conclusion? He says adding uncertainty doesn’t change the logic of his arguments, but is he assuming the uncertainty is constant over time? In short, I see nothing in his article that would help me at all in assessing future oil prices.

  12. Guest   May 19, 2008 at 10:39 pm

    Let’s look at the main factors driving the price of oil:Supply: War in Iraq & failure of the US role as a peace keeper in the region. Inflation: Money printed by the central banks to offset the bursting of asset bubbles that have accumulated since the end of Volker’s monetary policy from 1979-1982. The money supply may also be increasing as a result of some of the dislocations caused by globalization.Fundamental Demand: Explosive economic growth in China & IndiaMarket Demand: Lack of demand for any other major asset class: The equity market bubble burst @ 2001. The RE bubble is in the process of bursting. Inflation will probably hurt the bond and money markets. That leaves commodities. This induces a (price rise)-(commodity hoarding) feedback loop that leads to an exponential increase in prices (as the solution to the above equation also exhibits). A bare bones econometric regression of oil prices from 1986-2007 based upon fundamentals alone puts the current fundamental price of oil @ $60-$70/barrel. This suggests the market demand factors are dominating the price rise and that there may be something wrong with the data period…In fact, looking back at the above factors, one sees that the world today looks much more like it did in the 1970’s when oil prices roughly quadrupled and then doubled again. That would suggest that market oil prices should hit the $120-$240/barrel range.Aside from some recessionary and other corrections in oil prices, they probably won’t come down again until all the asset bubbles have been thoroughly digested by printed money, monetary austerity gives a few years of solid positive real interest rates accompanied by a taming of inflationary pressures, monetary easing follows, and other asset classes begin generate more attractive returns again.

  13. Anonymous   May 20, 2008 at 5:56 am

    This theoretical exploration of oil prices is interesting and useful — to a point.The first assumuption which must go out the window is that the market for oil, and thus the price-setting mechanism for oil, is efficient. The world is riddled with bad data in this sphere. Just look at the numbers thrown out by CERA as predictions of supply and demand, and how well have their predictions done over the past 3 years or so. Even within the Peak Oil camp, near peakists and late peakists can’t agree on the figures.The second assumption which must get thrown out is that the executives making decisions within the oil sector (be they private or national companies) operate outside the realm of psychology. An oil man who has been in the business for his whole life has been through a boom and bust cycle, probably multiple times. Do NOT try to tell me that the anchoring of these past events does not impact current decision making.Further, I did not see the word TAX mentioned once in Mr. Engel’s piece. You’re telling me that taxes and anticipation of taxes do not factor into this equation at all? I find that extremely unlikely. This all seems a bit simplistic, "when the real interest rate is low, producers have less incentive to take oil out of the ground. If they sell the oil today, what will they do with the money they earn? They’ll get a low rate of return, so they might as well keep the oil in the ground and sell it later." What if the interest rate is low, but so is the tax rate. Could not producers anticipate higher rates of taxation and thus maximize production now at lower tax rates? One does not have to look far for higher petroleum taxation: Venezuela, Alberta, Hillary Clinton stump speeches.This is not to argue that real interest rates are not a factor in crude production. However, I believe you cannot discount other equally relevant factors like anticipated future taxation and psychology. Perhaps for the purposes of the above simplistic theoretical exploration they can be ignored. The world does not operate under simplistic theoretical explanations though. My complaint about economists is that too many of them seem to forget that Economics is a social science closely akin to Psychology and not a branch of Mathematics.

  14. Anonymous   May 23, 2008 at 3:11 pm

    Pardon my naive comment, but isn’t it possible that there’s a fourth option that countries are hoarding oil based upon initial indications that several major sources like Saudi and Russia have peaked. What if producers want to make enough currency to maintain their high standard of living, but also wish to be the last nation pumping when other supplies dry up? Don’t you think the incentive is high to hold out for market monopoly status, even against less-desirable alternative sources like coal liquefaction, thermal depolymerization, and refined oil shale? New oil producers know that pumping and discovery costs are rising dramatically as their competition is being forced to switch to more expensive sources.Also, I highly doubt that the United States is the only nation hoarding oil in a strategic reserve, even as small as it is compared to our consumption. Originally, America’s strategic reserve was intended to control oil prices for the express purpose of preventing OPEC price hikes, not creating them. As you know, hoarding limits supply and increases demand.

  15. hlowe   May 25, 2008 at 6:50 pm

    Unfortunately for those who disagree, the empirical evidence is overwhelming. Whenever, real interest rates turn negative, the price of Oil and all other commodities take off. This shouldn’t be too surprising. When the returns on holding money are negative people will not swap their goods for it.Written by Jodie on 2008-05-19 19:01:24I agree!In addition to Mr. Engel’s points above, everyone should consider the value of the USD!! I suggest everyone be prepared for much higher prices if the dollar continues to sink. Check out the dollar index chart. We are a debtor nation who borrows to consume resulting in the rest of the world needing more and more of our devaluing dollars as they become worth less and less. As the dollar goes lower, commodities go up. The question should be why should the dollar go higher?

  16. Guest   May 27, 2008 at 10:54 pm

    Could it be price reflects the world has passed peak oil? As of now, 2006 was production peak. The implications are pervasive in an world economy totally dependent upon oil. Modern humans do not seem to understand the laws of thermodynamics; alternative energy is really an oxymoron. Time will prove this; ethanol gives us a foreshadowing. We seem to be approaching a near term shortage of diesel (distillates), and a severe shortage of exportable oil within just 3 to 5 years. Mobil Exxon quietly gave up on their big deep water find in the Gulf of Mexico; a possible indicator of the infeasibility of developing the new finds. Once it takes a barrel of oils’ worth of energy to get a barrel of oil out of the ground, the game is over, no matter the price. If markets are really as smart as free market idealogues assume, maybe the market actually understands that we are on the downhill extraction slope of an irreplaceable resource, and price is semi-steadily moving to a new equilibrium to reflect the precious quality of the remaining oil. What is the right price? $500? $1000? 10000?

  17. Guest   June 17, 2008 at 4:26 pm

    Does the element of continual surprise just mean that such markets are doomed to overshoot. It just seems like the current oil price drivers are overdetermined?