Price and Perception in Oil

The average price of oil through the first 10 months of 2008 now stands at 109.62.

But that’s not how it feels.

When oil spent four days above 145.00, most people felt they were living in a world of 150 dollar oil. Now that oil has touched down at 60 dollars several times, most people feel like oil has crashed.

Neither are really true. Moreover, these price prints drive a tremendous amount of analysis as perception and framing become anchored to the highs and lows. In paper assets, price highs and price lows are important. But in commodity prices, it’s the average price over time that’s more important. And this brings me to the theme of today’s post. There’s a ton of analytical error that’s visited each year on oil and other commodities, because it’s derived from the body of analysis that’s appropriate to paper assets.

One of the most common assertions now is that oil was in a speculative bubble. This is interesting, because in market history it’s hard to find a time when commodities were perceived as having been in bubbles. In market history, you will certainly find analysis asserting that French Bonds were in a bubble, or that Tulips or the South Sea Bubble, er, were bubbles. What you won’t find so easily is analysis stating, for example, that sugar or rubber shortages during war were “bubbles.” Or that “wheat in 1873 was the victim of a spectacular bubble.” Howcome? Because commodities have always been notoriously volatile.  So there is no need to substitute a complex reason for their price behavior when a simpler explanation will do.

Unlike paper assets, most commodities are consumed. In addition, commodities are physical assets and are often vulnerable to weather, infrastructure, transport, and other vagaries of the physical world. In other words, huge price swings are normal for commodities. So it’s not exactly clear what would ever qualify as a speculative bubble, in commodities. For example, if people hoarded cocoa at a time that cocoa was plentiful and the price of cocoa rose as a result, and the reason for the hoarding was a perception that war was coming with a neighboring country, and during this time there were profits (and losses) in the trading of cocoa–would this qualify as a speculative bubble, in cocoa? I think not.

This is why economists like James Hamilton and Paul Krugman both asserted over the last year that there was no speculative bubble in oil. Wait, let me correct that. They asserted there was no quantifiable evidence that there was a speculative bubble in oil. Rather, they both asserted the much simpler explanation for oil’s price behavior–supply and spare capacity were tight in the face of very strong demand. Indeed, for any person who cares to look at the data, non-OPEC production was flat for nearly 6 years as oil rose from 30.00 to above 140.00. And aggregate global production started to flatten in early 2005. And still has not risen.

No one asserts that speculation does not attend large price movements in commodities. Everyone grants that oil attracted speculation this decade, including Hamilton and Krugman. Some of that played around front month oil. Some of that played in the long end of the curve. Some of the speculation was short oil, in addition to being long. And of course, there were the ETFs which went long front month oil (and short front month oil).

The common assertion now that oil’s price rise this decade was the result of a speculative bubble is a pretty straightforward analytical error that stumbles over from the world of paper assets and finds itself lacking, in the world of commodities. Occam’s Razor points the way to a simpler explanation given that oil is delivered to a real user each month, and then consumed. But such non-trivial attributes to oil and the global oil market appear lost, on the bubble callers. Oil is not a stock that someone bought at 147.90, and was sold out at 62.00. Instead, oil looks to finish out the year for most people on the planet at an average price around 100.00. The hyper-sensitivity oil has to supply and demand shifts is the central thrust behind both the highs, and the lows. But as we close out 2008, the most remarkable fact of all has been the weak effect rising prices have had on global production. While expensive oil was enough to kill demand, it was not enough to yield a strong increase in global production. That is amazing.  And not a matter of perception.

-Gregor

Further reading: Charles Engel: Oil – Is there a Bubble?