- Black Gold and Fool's Gold:Speculation in the Oil Futures Market
On its face, nothing looks more like a classic bubble than the accelerating inflation of the oil price between 2003 and mid-2008, followed by a sudden collapse in late 2008. Starting from $30 per barrel, the price climbed fitfully but persistently to $100 per barrel at the end of 2007 and then shot up above $140 by July 2008, only to collapse below $40 by the end of 2008. Clearly the price spiked dramatically, but was it a bubble?
A large number of people have pointed their fingers at the growing flow of money into financial instruments tied to the oil price. These flows, they argue, pushed the oil price up and away from its fundamental level. The bubble burst when the general financial market collapse put an end to this dynamic. Some who make this argument speak with blanket disapproval of "speculation" and "speculators" because they are not part of the "real" oil business. Some go further still and suggest that financiers specifically "manipulated" the oil market. But the theory that the oil price spike was a speculative bubble driven by financial flows requires neither disapproval of purely financial investments in oil nor a judgment about motives. The thing about asset bubbles is that they arise naturally, so to speak, in any economy sophisticated enough to develop financial assets.
Among economists there is a prevailing skepticism toward the view that the oil price spike was a bubble.1 They point to the fact that the underlying fundamentals of supply and demand changed significantly in this period. [End Page 81] Economic growth was unexpectedly rapid and persistent in several developing countries, like China and India, which increased the demand for oil. Simultaneously, the supply of oil from some key sources fell, despite the rising price, and new sources were slow to appear. The only way to equilibrate this increasing demand and shortfall in supply was with a sharply rising price.
The argument that demand was the fundamental factor driving the price of oil up so sharply is bolstered by the fact that so many other commodity prices were rising dramatically at the same time. Many of these commodities are not traded on futures exchanges and are not assets that can be the subject of a bubble. These include various types of iron and steel and fabricated products, as well as cement. The price of things like engineering services increased dramatically as well.2
Rising global demand was clearly driving many prices sharply upward, and this was probably a major factor for the price of oil. The only question is whether changes in demand and supply curves for oil account for all of the movement in the price. Since there is no widely accepted measure of the global demand and supply curves for oil, it is difficult for economists to clearly demonstrate that the spike in the oil price is entirely determined by fundamentals.
A related source of skepticism among economists is the question of the missing stockpiles of oil. This is the dog that did not bark in the mystery of the oil price spike. If the price of oil were to be driven above its fundamental level at which supply and demand were matched, then consumers would cut back on use and producers would produce more. The quantity supplied would therefore exceed the quantity demanded, and the difference would have to go into a stockpile that someone (namely, the financial speculators) would be holding in hopes of a higher price in the future. Although the actual facts of supply and demand may be difficult to pin down, barrels of oil in storage are easy to count. No such stockpiles arose throughout the 2003-08 period, ergo financial speculation was not the cause of the oil price spike. It must have been supply and demand.
The economist's skepticism is generally a healthy one, but in this case, it is too dismissive. It overlooks how paper oil markets have been transformed. As I explain below, successful innovations in the financial industry made it possible for paper oil to be a financial asset in...