Another oil bubble? We can only speculate

As OPEC meets in Vienna market fundamentals point to another boom, but whether it occurs largely depends on the amount of speculation in the market.

Trading in paper barrels last year had reached 15 times the world production of oil of about 85 million barrels per day.

As oil prices have begun to rise steadily this year, the question is whether we are in for another oil price peak like the one last year, which could choke off the nascent recovery of the world economy. To see whether such an outcome is in the cards, one has to look closer at developments in the oil market last year, when oil prices shot up from $90 a barrel in January to a record high $147 a barrel in July. The main hypotheses that have been advanced to explain the jump in oil prices are market fundamentals and speculation.

These explanations can help answer two questions: first, was the oil price increase of over 50 per cent in the first six months of last year a bubble and the subsequent collapse to close to $30 a barrel in December the bursting of the bubble? And second, is a future bubble oil price likely? Fundamentals of demand and supply were certainly an important part of the story last year. The basic argument is that the price responsiveness of both the demand and supply of oil is very low, so that small changes in demand require large changes in prices for markets to clear.

Since world real GDP growth in the first half of last year was about the same as it was in 2007, one would expect the demand for oil to continue to expand and prices to rise. But in fact, world demand for crude oil actually fell to 86.3 million barrels per day (bpd) in the first half of last year from 86.5 million bpd in the second half of 2007. Furthermore, oil production rose to 86.8 million bpd from 85.8 million bpd over that same period.

Fundamentals would suggest that oil prices should have fallen in the first six months of last year. So market fundamentals alone cannot explain the spectacular rise in oil prices from January to June. The second hypothesis, speculation on the future price of oil, has received considerable attention. The argument runs as follows: while fundamentals were responsible for the rise in the equilibrium oil price, speculation led to overshooting of spot prices in the first half of last year and undershooting in the second half of the year.

Unfortunately, it is very difficult to measure speculation in any direct way. One obvious approach is to look at the volume of oil futures; it turns out that these have grown spectacularly over the past few years. In 2002 the average daily trading volume of oil futures (or "paper barrels" as they are known) was four times the daily world demand for oil (physical barrels). By last year, daily trading in paper barrels had reached 15 times the daily world production of oil (about 85 million bpd). Furthermore, the futures data are probably an underestimate since they do not include options or over-the-counter trades.

The volume of daily trading today is clear evidence of the enormous financialisation of the oil market that has taken place in only five to six years, and some part of this surely reflects speculative activities. Ideally, if one knew the equilibrium price of oil, determined by fundamentals, then one could figure out the effect of speculation. One indicator of the equilibrium price is the market valuation of major oil companies, which reflects long-term oil price expectations. Short-term deviations between valuations and spot prices are then temporary, or a "bubble".

But over the long run there should be a close relationship between spot oil prices and market valuations. The data lend considerable support to this idea. The steady rise in oil prices during 2003-07, because it was accompanied by a similar increase in oil company valuations, appears to have been "permanent". On the other hand, the steep rise in oil prices in the first half of last year, which resulted in a large deviation between crude prices and oil company equities, looks very much like a bubble.

The long-term, or permanent, component of crude oil prices based on corporate valuations was at that time between $80 and $90 a barrel, but spot prices were over $50 higher. On the downside, in December last year the actual spot price was between $20 and $30 below the corporate valuations price. What then does last year's experience imply for the future? Based on the market valuations indicator, a price of between $80 and $90 a barrel is clearly on the cards. In fact, spot prices are already more than $70 a barrel, so that day may be fast approaching.

Is another oil price bubble likely in the near future? While one cannot predict bubbles, 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 how much speculation there is in the oil market.

If the call by Gordon Brown, the prime minister of the UK, and Nicolas Sarkozy, the president of France, in The Wall Street Journal in July for the International Organisation of Securities Regulators to oversee the oil futures market is followed up, and the plans of the US Commodities Futures Trading Commission to place limits on aggregate positions on oil futures contracts are implemented, it would put a brake on speculation in the oil market and thereby reduce the likelihood of another bubble emerging.

Otherwise, it may well be that the $147 a barrel high last year will be repeated and perhaps even overtaken. Mohsin Khan is a senior fellow at the Peterson Institute for International Economics in Washington. Previously, he was director of the Middle East and Central Asia department of the IMF