No oil bubble in 2008

It’s really hard to defend the efficient markets hypothesis.  The theory seems so unrealistic.  I recall that when I began blogging in early 2009 the price of oil had just plummeted from $147/barrel to about $38/barrel.  It was hard to explain to people that the price of $147 was completely rational, given what investors knew in mid-2008.  That demand from developing countries had driven prices sky-high, not nefarious “speculators.”  Thus I had frequent debates with commenters.

But guess what happened.  When output recovered in the developing world prices shot right back up.  Not all the way to $147/barrel; after all, output is still quite depressed in the developed world.  But well over $100 for the so-called Brent crude (West Texas prices are currently distorted by pipeline limitations.) So now we know that speculators weren’t the cause of high prices in 2008, it was actual demand for oil.  James Hamilton is one of the world’s leading experts on oil prices, and he is very concerned about where we are going to get the oil to meet rising demand in countries like China:

In any case, the deed is now done, and the IEA has run an interesting experiment for us in how oil markets function. But I would recommend against further SPR sales, regardless of the final outcome of the current effort. The reason is that I see the long-run challenge of meeting the growing demand from the emerging economies as very daunting, and in my mind is the number one reason we’re talking about an oil price above $100/barrel in the first place.

Never sell the EMH short.  No matter how wrong it seems, no matter how irrational markets may seem, there is usually a rational expectation.


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26 Responses to “No oil bubble in 2008”

  1. Gravatar of Full Employment Hawk Full Employment Hawk
    14. July 2011 at 13:02

    The sale of oil from the reserves was an empirical test of whether there was an oil bubble. If there had been a bubble the sale would have burst it. And when the price of oil dropped to almost $90 at first, it looked like there had been a significant bubble. The fact that the price has partially recovered seems to indicate there has been no significant bubble.

    But we did have a housing bubble and a dot com stock bubble.

    Conclusion: Not all run ups in prices are bubbles, but some are.

  2. Gravatar of John Thacker John Thacker
    14. July 2011 at 13:37

    And when the price of oil dropped to almost $90 at first, it looked like there had been a significant bubble.

    But didn’t the price drop significantly before the public announcement of the sale from the reserves? (In fact, IIRC most of the drop was before the announcement.) If that drop had to do with the sale of the reserves, then that makes it seem like the drop was from people who knew or speculated about the government oil release from the SPR.

    I for one am continually surprised at the subset of people who simultaneously believe in peak oil and the need for conservation, yet blast “speculators” for causing oil prices to rise so high. They insist that prices shouldn’t rise yet because “demand and supply are in balance,” but if peak oil is true and we need to conserve, shouldn’t prices rise?

  3. Gravatar of Indy Indy
    14. July 2011 at 13:40

    Full Employment Hawk is correct, no oil bubble, “But we did have a housing bubble and a dot com stock bubble … Not all run ups in prices are bubbles, but some are.”

    I don’t think we’ll get very far in the discussion, however, without agreeing on definitions or conditions of verifiability or falsifiability. If the position is “no price vs. time chart can ever provide an example of a bubble” then the belief is of a sort that does not permit attack with evidence.

    Is there something on the order of “I’d believe in the possibility of the existence of market bubbles if I saw something that looked like [X…] “? Or is there no X?

  4. Gravatar of marcus nunes marcus nunes
    14. July 2011 at 13:48

    Scott
    My most popular post ever dealt exactly with that matter. Early this year every emerging market finance minister was pointing the finger at Bernanke and accusing him of fomenting “currency wars” and the like. I felt that, for once, he could be “defended”:
    http://thefaintofheart.wordpress.com/2011/02/06/bernanke-and-higher-food-commodity-prices/

  5. Gravatar of JLonsdale JLonsdale
    14. July 2011 at 13:51

    There being a rational explanation for why markets are where they are is different from there being a sustainable reason. LinkedIn’s valuation is high mainly because there are tons of equity investors who are desperate to get into social companies (Look at what happened to GSV’s stock after they announced their Facebook purchase) combined with its very small float.

    It cost 25% a year to borrow it in order to short. The option implied volatility is 100% for ATM calls.

    Sure, it’s hard to make money in this situation (some people might argue that delta hedging calls is the way to do it here) but that doesn’t mean that we should take the idea that the company is worth 10 billion dollars seriously. Markets move for reasons inherent in market dynamics which are not always tied to economic fundamentals. Acting like the EMH means that markets are always predicting things is a really strong assumption.

  6. Gravatar of Scott Sumner Scott Sumner
    14. July 2011 at 14:20

    FEH, Yes, but how do you know ahead of time which ones? And if you knew for sure, would the bubble have happened?

    John, I find not 1 person in 100 understands supply and demand.

    Indy, The bottom line is whether the anti-EMH position (bubbles can be spotted) has investment or policy implications. I keep trying to show it doesn’t.

    Marcus, I agree. It’s much more China than the Fed. When China began recovering in 2009 that’s when commodities turned up.

    JLonsdale, You said;

    “Markets move for reasons inherent in market dynamics which are not always tied to economic fundamentals.”

    Markets always move for the exact same reason–expectations. You are saying that some expectations are correct and others aren’t. Yes, but the EMH allows for that.

  7. Gravatar of Benjamin Cole Benjamin Cole
    14. July 2011 at 15:32

    Finally I disagree with Scott Sumner!

    Oil and the NYMEX, and dark pools of capital trading anonymously though European fronts. This is a peculiar market.

    For one, demand is short-term price inelastic. It is even medium-termish inelastic, if demand does not falter due to recession. Add to that, there is an above-ground organization–OPEC–dedicated to higher prices (ala Texas Railroad Commission). Bad luck on top: so many oil-producing nations are thug states. A contract means you have a piece of paper. Add to that several dubious websites devoted to oil scaremongering, and who knows who is lining the pockets of blabbering “experts.”

    So, if a sovereign wealth fund, identity cloaked and operating through a front, PR campaign firing, can try to game the market, it will. Let’s say the price is gamed higher–demand does not fall right away. You can get a good run out of higher oil prices, probably for years (depending on how much higher, of course). Let us add that a Putin would be remiss in his patriotic duties if he did not at least try to game prices higher. We can assume he is trying.

    Now, yes, eventually the chickens come home to roost. Oil at more than $100 a barrel sets in motion conservation, alternatives, new production. Much higher mpg cars. Shale gas, which can liquified into methanol, or used as CNG. There is a wealth of options, but all slow in the making.

    Actually, I think the gaming of the NYMEX may be counter-productive, even for the nations that immediately benefit (though the Goldman traders likely make out well). Huge forces are set in motion, and demand will soften, and not just for a few years, but decades.

    The research going on into lithium batteries is remarkable.

    I think the future will be cleaner and more prosperous–a perfectly wonderful option in years ahead is clean cities, in which PHEVs are mandated, or heavily encouraged (or ICE’s discouraged). After all, where is the right to pollute air people breath, or to send pollution onto someone else’s private property?

    But I would not use oil to prove the EMH. I suspect it is a whack-job market at best, and probably rigged at worst.

  8. Gravatar of MarkS MarkS
    14. July 2011 at 15:47

    You admitted previously that you have no real experience in banking and that you’re not an expert in banking. Yet you feel compelled to lecture people on monetary policy (of which banking is a key element).

    Now, you’re lecturing people on markets and efficiency. Scott, have you ever worked on a trading desk at a major bank? Have you ever traded billions or even hundreds of millions of dollars? If not, you are not qualified to discuss these matters because without experience in the trenches you would have no idea how much manipulation and speculation actually goes on inside these banks.

    I know, because I work at one and see it every day. But I’ve tried to teach you about banking in the past and you had none of it so I would expect you to do the same here.

  9. Gravatar of Jon Jon
    14. July 2011 at 15:48

    It was hard to explain to people that the price of $147 was completely rational, given what investors knew in mid-2008. That demand from developing countries had driven prices sky-high, not nefarious “speculators.” Thus I had frequent debates with commenters.

    Or as I argued with you that there were also unexpected (transient) production short-falls*. The future _might_ be bleak (lots of demand growth, little supply growth) but the oil price today is clearly sensitive to market conditions today–that’s why it went so low when the crisis hit.

    If you really believe in the EMH, you shouldn’t claim so often there is an imminent oil crunch. The price of oil is simply too low to support the claim that supply growth will fall short of demand-growth within ten years time, or are carrying costs in salt caverns such as are used for the SPR really that high? Actually they are pretty low.

    * The latest bit of information to support this: Saudi oil output recent boosted by 700K bpd, merely increases output to levels last seen in early 2006.

  10. Gravatar of JLonsdale JLonsdale
    14. July 2011 at 16:16

    >Markets always move for the exact same reason-expectations. You are saying that some expectations are correct and others aren’t. Yes, but the EMH allows for that.

    No, it isn’t just about expectations. It is also about market mechanics. When there are forced sellers or people who are prevented from being sellers (or buyers) markets will be skewed. In the case of LNKD, the market price would be different if many of the employees were allowed to sell their stock and if short sellers were able to more easily borrow the stock.

    In the case of TIPs, a lot of its movements in the crisis can be attributed to funds having to sell an assets to meet margin calls and the TIPs were among their most liquid options. This type of forced selling can move the market away from actual expectations, especially as other institutions also saw their balance sheets contracting and so were unable to take advantage of the fire sale (And because there were better deals than TIPs, although those were what I bought).

    If you want to believe that there are no identifiable market opportunities out there we can agree to disagree on that (Though I would recommend that you read the excellent “Finding Alpha” by Eric Falkenstein of Falkenblog for stories of market inefficiencies even an economist would admit were not based around expectations that lasted for some time), but I would recommend that you think a little more about how constrained markets might not always be measuring expectations.

  11. Gravatar of Matt Waters Matt Waters
    14. July 2011 at 16:54

    Well, I’ll ask a question that I’m sure will get an interesting response. Do you think gold is in a bubble right now or is the market rational in basically building in hyperinflation expectations into the current price?

  12. Gravatar of Lorenzo from Oz Lorenzo from Oz
    14. July 2011 at 17:44

    If we could reliably identify bubbles ahead of time, there wouldn’t be any. Because if the turning point could be determined, people would not be caught by it, so prices would not rise to that point so … Bubbles exist because we cannot reliably spot turning points. Expectations are what we have instead of actual knowledge of the future.

    The question becomes: what are those expectations based on? In asset markets, if it turns out those expectations were based on expectations (of capital gains), then we have a bubble which bursts when those expectations collapse. In housing markets, rents tell the story of actual supply and demand. If prices are rising way faster than rents, then they are rising beyond expected income value and the prices have an expectation of capital gain built into them which–at some unknown point–will collapse back to their income value (unless rents “catch up”). I believe Oz has a series of housing bubbles but there is no telling when they will burst. There could be more bubble yet to come. Predicting when a bubble will burst cannot be reliably done, that is why they happen: this is where we came in.

    I fail to see how complaining that you cannot reliably identify bubble turning points ahead of time is some “refutation” of the nature of bubbles. Still less of the EMH, for surely widespread expectations of capital gain are also information.

    I suspect the ‘Efficient’ in “Efficient Market Hypothesis” does some rhetorical/analytical damage here by implying that there is something “intrinsically correct” about the market price as distinct from simply incorporating available information; just as I have come to the conclusion that “real” as in ‘real prices’ and ‘real wages’ does also such damage by encouraging inappropriate belief in monetary “transparency”, ignoring or belittling the simplifying, information and past obligations role of money as the medium of account.

  13. Gravatar of Matt Waters Matt Waters
    14. July 2011 at 20:05

    Lorenzo,

    I could not find the study, but I remember one study which showed how bubbles develop despite clear expectations.

    A bunch of people were put at computers and traded fake securities with each other. The securities had set expected dividends and a set liquidating dividend at the end. The dividends had 50% chance of happening, which created some uncertainty, but there was no uncertainty about the expected dividends. Whoever had the most dividends and capital gains on sales made some real money at the end.

    It turned out that the security prices quickly became unhinged from the fundamental value of the dividends. Everybody tried to speculate and get somebody else to buy it for higher. You didn’t make a lot of money through doing fundamental analysis but by riding the bubble. Then towards the end the stock cratered to the value of its liquidating dividend once the last people in found no buyers.

    When they repeated this experiment with the same exact parameters, the bubble did not go up as high. After their experience the first time, the participants learned not to push the speculation too far. However, if the parameters of the dividends changed somewhat, the speculative craze would happen all over again.

    So there might not be bubbles in markets where participants have a lot of experience, but in newer markets bubbles do happen due to inexperience with the underlying dividends. In the late-90’s, there was not a bubble in boring stocks like Caterpillar. The bubble happened in tech stocks which had buyers who did not really know how to treat the earnings of tech companies. They thought that somehow there would be some earnings at the end and kept riding the speculative bubble until it popped. Now that we’re entering another possible tech bubble, the market is generally far more cautious and the bubble will probably be less frothy.

    It’s also worth noting that many people did call both the tech and housing bubble. Warren Buffett pointed out in 1999 that the stock indices only made sense if there was a combination of unprecedented growth in GDP, much lower interest rates and/or an unprecedented percentage of GDP went to corporate profits. Such a combination had never happened and as Buffett predicted, the indices tanked once the market woke up to the real cash flows of most tech firms.

    Finally, your post shows what I think is the real danger of EMH. The EMH is true in broad strokes. If I had to guess the “correct” price of Norfolk Southern’s stock, I would use the stock market’s price unless I had some big insight for why not to. But the EMH also implies that bubbles don’t happen and the market never fundamentally misprices a security. That just isn’t true. Bubbles do happen and markets become fundamentally unhinged from their underlying cash flows.

    But once you believe the market doesn’t misprice anything, then regulators and investors become justified in using market prices to implement financial regulation or financial decisions. That clearly can have very adverse consequences since bubbles can also inflate bank assets and make them more “capitalized” when the capital is really illusionary.

  14. Gravatar of Matt Waters Matt Waters
    14. July 2011 at 20:21

    Lorenzo,

    I apologizing for skimming your post too quickly and not really reading the last two paragraphs. Were basically saying the same thing.

    To summarize my last post, part of the “expectations” built into bubbles is that the price will appreciate regardless of fundamental value. As you say, it does not really make sense how house prices could become unhinged from rent unless the market was speculating and creating a bubble.

    And the “efficient” in EMH has done a lot of harm the past 30 years. Maybe more refined versions of the EMH do not say pricing always reflects fundamental value, but it has come out in many economics and finance classes that prices are always correct because markets are always perfect. Of course that just isn’t true.

  15. Gravatar of Lance Lance
    14. July 2011 at 20:23

    A lot of this debate comes down to what people mean by “speculation”. Weak definitions merely assert that the futures price of oil influences the spot price. You cannot deny that. A strong form argues that oil has deviated from its fundamental value due to futures being traded as a financial product.

    Theoretically, you can outline a case where speculative activity could cause the price of oil to be higher than its fundamental value. However, this should show up in oil inventories, or capacity utilization rates. There are a few papers on SSRN relating to this, but I haven’t seen too many convincing empirical papers arguing one way or the other.

  16. Gravatar of TheNumeraire TheNumeraire
    15. July 2011 at 01:48

    Marcus, I found the link you provided to be both interesting and informative — but I do believe some of your figures overstate the “it’s mostly China” case.

    Correct me if I’m wrong, but your figures on Chinese imports appear to be nominal dollar values, not volumes or units. If so, this is problematic because without more information, we cannot confirm how much of the nominal increase is from increased volume and how much is related to changes in the value of the unit of account (in this instance, the dollar).

    You state that “after gaining access to the World Trade Organization (WTO) in late 2001, Chinese imports increase by a factor of 7 over the next 8 years. To put this in perspective, over the previous 8 years it had gone by a factor of “only” 2.8.”. How does one derive how much of the sevenfold increase in Chinese imports is due to expanding volume and how much is due to rising prices for oil, copper etc.?

    Oil is a relatively large and important component of Chinese import — China currently consumes 10mil bpd of oil and imports a little less than half of total consumption. However, Chinese oil consumption in terms of bpd has only tripled since 1995 — in dollar volumes, consumption has grown by a factor of somewhere near fifteenfold.

  17. Gravatar of marcus nunes marcus nunes
    15. July 2011 at 03:35

    TheNumeraire
    I concede your point. But qualitatively the conclusion would be the same from examining the behavior of industrial production growth in emerging market economies, a volume measure, and Chinese imports.

  18. Gravatar of Scott Sumner Scott Sumner
    15. July 2011 at 05:51

    Benjamin, It wouldn’t surprise me if $100 oil is the new normal, given exploding demand in Asia.

    Mark, You said;

    “You admitted previously that you have no real experience in banking and that you’re not an expert in banking. Yet you feel compelled to lecture people on monetary policy (of which banking is a key element).”

    No it isn’t. You are confusing money and credit.

    And I very much doubt banks are manipulating world oil prices–if there were they’d lose money. Milton Friedman showed that speculators only make money if the stabilize market prices, not destabilize prices. But I suppose Milton Friedman also knows nothing about banking.

    Jon, My arguments about future demand are to explain why the price is as high as it is, not that markets are inefficient.

    JLonsdale, I’ve never argued markets are perfect, just that the anti-EMH is not useful.

    Matt, Neither, I think gold demand is coming from Asia, just like the soaring prices of other commodities.

    Lorenzo, People often confuse efficient markets with perfect markets. Yes, after the fact prices might look foolish. But as we saw with Australia, it’s not possible to know ex ante which prices are right, and which are wrong. Australian prices looked absurdly high in 2005–now most consider those prices to be a great bargain. The anti-EMHers were wrong. Eventually Aussie prices will fall, and the anti-EMHers will say I told you so. But they will still have been wrong, they just won’t understand why they were wrong. Predict anything long enough and it will happen.

    Matt, Whether you think the EMH denies bubbles depends entirely on how you define “bubble.” The average person defines bubble as a big price run-up followed by a crash. The EMH allows for those bubbles. What it says is that you don’t know it’s a bubble until after the fact. Yes some people were right about American housing prices, but the same people were wrong about Australian housing prices, and lots of other countries. It’s a coin flip. Sometimes you get lucky.

    Matt, You said;

    “finance classes that prices are always correct because markets are always perfect. Of course that just isn’t true.”

    It’s unfortunate that my side has so many stupid finance professors, who don’t understand the EMH. The damage from the anti-EMH is profound. It causes Americans to waste massive amounts of money in managed funds. It caused money to be too tight in late 2008, as the Fed ignored that markets which were telling us that NGDP was plunging.

    Lance, Good point.

  19. Gravatar of Full Employment Hawk Full Employment Hawk
    15. July 2011 at 07:45

    “Yes, but how do you know ahead of time which ones? And if you knew for sure, would the bubble have happened?”

    When we observe that people are buying an asset, not because they believe the price is justified by fundamentals, but because they believe that the price of the asset will go up, so that if they buy it now they will be able to sell it later at a higher price to a greater fool who, in turn, believes that the price will go up some more (example: flip this house), we have a bubble. When the price has gotten so high that there are not enough greater fools who think the price will go up some more, to buy the asset at the very high price it has reached, the bubble bursts. Astute investors who are immune from market psychology can observe this and correctly conclude that there is a bubble. For example, Paul Krugman with respect to the housing bubble. Just having predicted the price of houses would drop does not prove superior insight because it may have just been a lucky guess. But if one argues that it is a bubble and gives reasons for concluding that it is a bubble, and those reasons turn out to be the correct reasons why it was a bubble, that demonstrates superior insight. Krugman did that.

    If the market was dominated by people who believed that further price increases for an asset are not justified by the fundamentals and any further increases would involve a bubble, the bubble would not have happened. But what we get during a bubble is that the people who believe that it is a bubble are in the minority and not determining the price. The market is dominated by people who do not realize that it is a bubble. For the people who believe that this is a bubble to sell short while the bubble is happening will cause them to lose their shirts. As a matter of fact, even people who realize it is a bubble but are not too risk averse may, if they think the bubble will last for a significant period longer, buy the asset on the expectation that they will be able to sell it at a higher price to a greater fool before the bubble bursts.

  20. Gravatar of Full Employment Hawk Full Employment Hawk
    15. July 2011 at 08:03

    “Because if the turning point could be determined, people would not be caught by it”

    That is a crucial point. Even people who recognize that a run up in prices is a bubble cannot determine when the bubble will burst. They know that the bubble will burst some time on the future, but not when. None of the people who recognized that the dot com stock price run up was a bubble were able to predict when it would burst, and the same was true for the housing bubble.

  21. Gravatar of ssumner ssumner
    15. July 2011 at 10:07

    FEH, I don’t agree that bubbles can be spotted in real time. The housing bubble spotters in 2005 were right about the US and Ireland, but wrong about most countries–where prices didn’t collapse.

    In some countries they went much higher.

    Krugman got lucky.

  22. Gravatar of Jim W. Jim W.
    15. July 2011 at 11:03

    Scott,

    While I agree with your general assertion that there are no “bubbles” I think you are woefully uninformed on the mechanics of the oil futures market which determines spot pricing of crude.

    Please see the linked paper which details the large increase of non commercial traders (where no oil is received/delivered) in the market over the last decade. The impact of this group has changed the historical pattern of crude pricing and has tied it closer to the value of the dollar. This is the “speculation” in the market.

    http://bakerinstitute.org/publications/EF-pub-MedlockJaffeOilFuturesMarket-082609.pdf

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  24. Gravatar of Scott Sumner Scott Sumner
    16. July 2011 at 09:43

    Jim, Speculation tends to reduce the volatility of prices, otherwise the speculators make no money.

  25. Gravatar of Full Employment Hawk Full Employment Hawk
    16. July 2011 at 12:28

    “Speculation tends to reduce the volatility of prices, otherwise the speculators make no money.”

    That is true in the long run. But that does not exclude speculators increasing the volatility of prices for a significant period of time. Yes, they will be losing their shirts during this time. But people who engage in speculation tend to have a large amount of economic resources and can afford to lose a lot of money without going bankrupt and being driven out of the market. This is especially the case because many of the resources being brought into the speculation can be money earned in other places than the market in which the speculation is taking place. This is why even though gambing causes the gamblers to lose money in the long run, gambling has not been driven out of business because all gamblers have gone bankrupt because of their losses. They bring money they have earned elsewhere into the gambling market.

  26. Gravatar of Scott Sumner Scott Sumner
    17. July 2011 at 16:41

    FEH, My point is that if we are considering speculators as an institution, then tend to reduce volatility. Even in the cases where they (ex post) increase volatility, there’d be no way for regulators to know.

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