The Oil Bubble - Part 2

In Part 1 of “The Oil Bubble”, we looked at the current price appreciation in crude prices and tried to determine if it was sustainable or not. We compared the recent run-up to other various commodities, all of which have corrected sharply, and also compared the multi-year advance to other bubbles like the tech bubble of the late 90s and the more recent housing bubble. Our conclusion is that oil is indeed a bubble, but that it is difficult to determine what inning of the game we are in, to use a mixed metaphor.

In this missive, we are going to look at the causes of the sharp ascent in oil prices. The media has run countless stories about who is to blame, and Congress has even hauled in big oil executives to point the finger and demand answers from them. But as we will discuss in a bit, Congress should really take a more introspective look if they want concrete answers.

Economics 101 tells us that the rise in the price of a good is purely a function of supply and demand, and specifically the intersection where the two reach equilibrium. As such, if demand rises while supply is held constant, prices need to rise for the market to remain at equilibrium. So let’s take a look at both supply and demand, both of which have played a role in the oil bubble.

First, most observers consider it a foregone conclusion that demand has skyrocketed, due to the large number of new consumers that have emerged in countries like China and India. But the recent run-up in oil prices has far outpaced anything seen on the demand side.

Global oil consumption grew +2% in the first quarter of this year, while production increased +2.5%. So there is not an outsized amount of demand being physically consumed. That means that a large amount of demand is coming from speculators, who drive the futures prices of oil higher purely for investment reasons.

Institutional investors, battered by the bear market in 200-02, turned to a new so-called asset class in the form of commodities. Investment demand came from all sorts of institutions, from hedge funds, endowments, pension funds, Sovereign wealth funds, and exchange-traded funds. In the first quarter of 2008 alone, global investments in commodity indexes rose $40 billion (+28% yr/yr) to $185 billion, a larger gain that all of 2007, according to Citigroup.

Hedge fund manager Michael Masters testified before Congress last week that while China’s demand for oil has increased by 920mn barrels in the past 5 years, demand for petroleum index futures has increased by 848mn barrels. This means the effect of speculators in just about as large at all the growth from China. Pretty amazing.

So it’s clear that demand is rising, but it’s not just from growth in emerging market economies. That part of the equation is relatively easy to quantify. The wildcard, and the one which I believe has more to do with the recent parabolic spike we’ve seen in crude prices, is from the new “Index Speculators” as Mr. Masters has called them, or institutional investors.

In Part 3, I will delve into the supply side of the equation, and how Congress is really trying to deflect blame by casting the big oil companies as the enemy.