A Balanced View of Oil Prices, The Economy and Speculation

James Hamilton, the distinguished economist and author of the Econbrowser blog, is delivering a paper (for the pdf file click here) to the Brookings Institution that discusses the causes of the 2007-08 oil price shock and its impact on the subsequent recession. This is a wide-ranging, thoughtful piece and he tackles some of the tough issues, including the role of speculation:

With hindsight, it is hard to deny that the price rose too high in July 2008, and that this miscalculation was influenced in part by the flow of investment dollars into commodity futures contracts. It is worth emphasizing, however, that the two key ingredients needed to make such a story coherent— a low price elasticity of demand, and the failure of physical production to increase— are the same key elements of a fundamentals-based explanation of the same phenomenon. I therefore conclude that these two factors, rather than speculation per se, should be construed as the primary cause of the oil shock of 2007-08.

I think this is about right — there were real fundamentals behind the oil run-up, but speculation made it unnecessarily worse. I do think Hamilton is showing the academic economist’s bias of underestimating that which can’t be measured — speculative influences — in favor of the more easily measurable supply and demand statistics, but it’s notable and laudable that he does recognize that speculation played a role. In my own Congressional testimony about the commodity speculation’s role, I stated that the issue was not just the degree to which investment inflows had already influenced prices, but also the degree to which they would in the future:

In all these considerations, one can argue in good faith whether index speculators create a large or a small impact. Those that believe there is only a minimal influence should consider a future when these index speculators will command far greater assets.

In his piece, Hamilton tries to quantify the impact that the oil runup had on the recession. He concludes with the belief that we would not have entered the recession without the oil price shock. Clearly, the energy price bubble has had a huge cost. Hamilton also does not include the damage caused by the disruptions in other commodity markets. In some of these areas, notably the cotton and grains markets, the impact of speculation was far more dramatic and, to my mind, evident. The bubble and subsequent bust exacerbated by speculation has had profound economic and human costs.

It is disappointing and troubling that the speculative tools that contributed to that run-up (commodity swaps) and the closely related speculative tools that created so much systemic risk in the financial system (credit default swaps) remain largely unregulated. Hamilton argues that the fundamentals behind some of the energy price increases will rise again in an economic recovery. Our policymakers need to have addressed the regulatory deficiencies if we are to avoid a replay of 2008’s speculative excesses and their subsequent disastrous costs.

Comments

[Ferdinand E...:]

I have no problem at all believing that speculation did not cause the oil price run-up. Demand outran supply because the suppliers - especially OPEC - are not going to put the welfare of motorists in the oil importing countries ahead of the welfare of their own citizens. If you want to explain what happened that is quite enough.

Algebraically it can be easily shown that in a linear difference or differential equation system - constructed from supply-demand equations - we can get a rising or falling trend, with oscillations around the trend. It is easily to choose parameters so that the oscillations are explosive, but to get this result easier still work with non-linear demand and/or supply equations.

But yes, speculation make it worse, but it did not have to enter the picture. Even if speculators were banished to Devil's Island, when the global macroeconomy recovers, the oil price is going to rise. Just hope that it does not rise too fast..

Apr 05 09:02 AM

[ghassan karam:]

If one is to suggest that the major factor behind the increase in the price of oil is the dficit in demand then there is no basis to suggest that the deficit could have been bridged by increased production from OPEC.
The fact of the matter is that the most important reason for the increase in the price of oil is a scarcity in supplies but that shortage is not an artificial one. The world is at Peak Oil and just cannot increase production beyond the 86 million barrels a day. That is why the oil price crisi will be revisited as soon as the world economies resume their growth.


On Apr 05 09:02 AM Ferdinand E. Banks wrote:

> I have no problem at all believing that speculation did not cause
> the oil price run-up. Demand outran supply because the suppliers
> - especially OPEC - are not going to put the welfare of motorists
> in the oil importing countries ahead of the welfare of their own
> citizens. If you want to explain what happened that is quite enough.
>
>
> Algebraically it can be easily shown that in a linear difference
> or differential equation system - constructed from supply-demand
> equations - we can get a rising or falling trend, with oscillations
> around the trend. It is easily to choose parameters so that the oscillations
> are explosive, but to get this result easier still work with non-linear
> demand and/or supply equations.
>
> But yes, speculation make it worse, but it did not have to enter
> the picture. Even if speculators were banished to Devil's Island,
> when the global macroeconomy recovers, the oil price is going to
> rise. Just hope that it does not rise too fast..

Apr 05 10:44 AM

[sikarskie:]

During the oil run up of 08..the fundamentals were thrown out the window...every expert gave opinions to sell readership ...perhaps funded by big oil to falsely run up prices or by accident ..the same result happened..the only way to control this from happening again is to modify the margin requirements for the oil and gas industry to 50% margin rather than 5 %....Lawrence Sikarskie

Apr 05 12:58 PM

[jr007:]

The ultimate answer to the entire oil problem is to replace oil with a sustainable aternative. Oil is not a renewable resource... once it is exhausted it will not be back....The price of oil will rise in proportion to the cost and availablity of a viable alternative. Lets hope that some sanity prevails during the process.

Apr 05 01:22 PM

[Randy Miller:]

Hamilton's Econbrowser website is usually interesting. All during the runup in oil and gasoline prices last summer, he and some of his brethren on that site kept saying, no this is not caused by speculation, it is caused purely by supply and demand. I just read through the section of his Brookings Institute paper about speculation. He starts out by saying it is hard to deny that this was a bubble that burst, and spends the rest of the section denying that it was the primary cause.

I will agree that the long term trend from January 2005 ($42/bbl) to August 2007 ($68/bbl) could be almost totally explained by supply and demand factors. The price of oil in 2005 was too low to cover replacement cost of extraction. When the replacement cost of the last incremental barrel pumped is around $60, how do you justify $96 oil, let alone $148?


According to data from the EIA website showing crude oil stocks, stocks only went down 2/10ths of 1 percent between Aug 2007 and Aug 2008. For prices to double in the time period could only be explained by a true shortage, (which was not the case as shown by that infinitesimal drop), speculation, or panic buying.

Think back to 2008.

Every time the Nigerian rebels blew up a pipe line, the media trotted out some expert who would tell us of the downward impact on oil supplies. That would be followed by some "expert" from Goldman Sachs or Morgan Stanley telling us the impact on price. And the price would rise.

A week or two later, the Israelis would threaten military action against Iran. Some expert would give us a dire forecast on the supply impact if the Iranians closed the straits of Hormuz. Then the experts at GS or MS would predict another price rise. Lo and behold the price would rise.

Then there was one day the price went up $10 per barrel. This time the honest smart money said no, that was not supply in demand, that was short sellers covering their positions, and had to pay anything to cover their bets. The following week, the price receded about $5.

The price exploded because of PERCEIVED SHORTAGE AT SOME FUTURE TIME. The same things happened in the grain markets. The huge runup in the grain markets led to the slaughter of large cow herds, and our national cow herd dropped to its lowest levels since the fifties. Hog farmers in this part of Iowa aborted pig litters because they could not profitably feed them at those inflated prices.

In oil and grain, projected shortages enabled speculators to run up prices. Supply and demand had some effect, but those shortages never really materialized, and prices of oil and grain dropped. By that time, the agricultural sector had over compensated, and we will be feeling the effects for years.

So, when Hamilton and others cling to their supply/ demand paradigms, and rule out speculation as a primary cause, they do damage. That damage is caused when some legislator quotes them saying this was all about supply and demand, therefore we should not take any action to penalize speculation.

Action items: First, quit calling speculators investors. An investor is someone who wants to improve the true VALUE of an asset, instead of just the price. A speculator is someone who wants to hold an asset to realize price gain and sell it at a speculative profit, or someone who short sells for speculative profit.

Second, use the tax code to reward genuine investors and entrepreneurs with low capital gains taxes, and set the tax rate for speculative profits at 90 percent.

Apr 05 02:42 PM

[socialismSUCKS:]

Agreed, but let's just hope that free market sanity, not government central planning, is the prevailing force.


On Apr 05 01:22 PM jr007 wrote:

> The ultimate answer to the entire oil problem is to replace oil with
> a sustainable aternative. Oil is not a renewable resource... once
> it is exhausted it will not be back....The price of oil will rise
> in proportion to the cost and availablity of a viable alternative.
> Lets hope that some sanity prevails during the process.

Apr 05 03:42 PM

[Timo:]

You're all right of course,niceone!

Apr 05 04:27 PM

[SeekingTruth:]

To Randy Miller:
I think that you are closest to the truth in this discussion.

Speculation is such a powerful influence in today's markets that I think that the traditional supply/demand curves should be amended to include it .
Of course , most of us don't have the 100 years of time to wait for the conventional academics to catch up,
NOR SHOULD WE!

Apr 05 08:04 PM

[Tom Armistead:]

The last paragraph makes a very important point - that commodities futures and credit default swaps, both of which played a major role in exacerbating the financial crisis, are subject to little if any regulation.

I agree with the author's conclusion that we must address these regulatory deficiencies.

If Geithner's proposal for a central risk regulator becomes reality, one of his first actions should be to make a review of all financial products that create systemic risk, to ensure that these products serve legitimate investment or hedging needs rather than speculation. CDS and commodities futures should be at the head of the list.

Apr 05 09:02 PM

[Fighting Yoda:]

It was all speculation, fund inflows are the surest easiest measure. The speculation died only because of the burst of the credit bubble – no more easy money available to speculate.

This commodity/oil bubble was caused/exacerbated by money easing from Bernanke in August ’07. Remember despite all the turmoil – the markets went even higher till Oct ’07, and commodities peaked only on July ’08. The fool Bernanke does not understand the implications of unintended consequences. If not for the commodity bubble we will not have such a major recession. Now we will continue with a even worse recession because – we continue to follow the policy of easy cheap money. This will have much larger and worse consequence in a couple of years.

Meanwhile we are headed into deflation – don’t buy into the commodities.

Apr 06 04:13 AM

[Dr. O:]

We've seen that speculation can run up markets as large as the US stock market (remember Nasdaq 5000?) or the US housing market (remember condoflip.com?).

Given that in good economic conditions there is an inelastic supply of oil (running full out oil producers can only produce a given amount), the oil market certainly did and certainly can be "run up" by speculators.

In fact, it's already started to happen again. While many experts agree that the world is currently awash in oil (hence the multiple OPEC production cuts), the price at $50 carries an "Iran premium."

The "Iran premium" reflects the heightening tensions between Iran, the UN, and particularly Israel. Many have speculated that newly elected Israeli Prime Minister Netanyahu will launch a strike on Iran's nuclear facilities, leading to chaos in the oil markets.

Apr 06 09:24 AM

[Daniel J Sw...:]

From a standpoint of physics, the Industrial economy as it is currently configured HAD to go into recession to stay within what was available.
In our current Industrial economy economic activity consumes energy from fossil fuel. We were using everything that we had, and we were experiencing spot shortages. The press is not serving us well, and they glossed over the jet fuel, diesel fuel, and gasoline shortages that we had just before the economic collapse. Because they do not understand the big picture, their reporting cannot be used to learn the big picture.
The next thing that will happen looks to me like a very short economic recovery, with energy prices higher than ever before. We are literally stimulating an economy that has no sustainability, and it will behave like one.
Dan
www.energystrain.com

Apr 06 09:46 AM

[CPST1:]

Timeout!

Chairman Ben S. Bernanke
At the Federal Reserve Bank of Kansas City's Economic Symposium, Jackson Hole, Wyoming
August 31, 2007
Housing, Housing Finance, and Monetary Policy

www.federalreserve.gov...


On Apr 06 04:13 AM Fighting Yoda wrote:

> It was all speculation, fund inflows are the surest easiest measure.
> The speculation died only because of the burst of the credit bubble
> – no more easy money available to speculate.
>
> This commodity/oil bubble was caused/exacerbated by money easing
> from Bernanke in August ’07. Remember despite all the turmoil – the
> markets went even higher till Oct ’07, and commodities peaked only
> on July ’08. The fool Bernanke does not understand the implications
> of unintended consequences. If not for the commodity bubble we will
> not have such a major recession. Now we will continue with a even
> worse recession because – we continue to follow the policy of easy
> cheap money. This will have much larger and worse consequence in
> a couple of years.
>
> Meanwhile we are headed into deflation – don’t buy into the commodities.
>

Apr 06 12:50 PM

[amdman:]

These ex-Enron traders exposed by 60-Minutes are just not going to give up spreading this dis-information, so that they can continue their scams.
Just look at the Gold market where trading dollars exceed actual gold sales by a thousand to one. These speculators can run the market up to ridiculous highs or lows, completely divorced from supply or demand.
All that matters is that the big money and the sheep are on opposite sides of the trade, then the price will swing. The sheep are suckered in by articles like this one paid for by the speculators.

Apr 06 02:27 PM

[User 353732:]

Oil is at intersection of several potent forces, some global in their range and others national. They range from geo-politics, oil industry and financial engineering technology, anticipated growth in use and investments in production capacity, inventory management(especially secondary and tertiary), government policies regarding access to exploration and conditions for production , technology, logistics and refining capacity, wars and rumors of wars, terrorism and sabotage, rapid money flows impelled by momentum investors with access to staggering amounts of almost free debt, Wall Street desire to induce transactions and actual or percieved direct competition from natural gas and indirect competition from coal and nuclear. No one factor is dominant and the relevant influence of various factors keeps changing in ways that even the most experienced industry insiders do not understand. Oil is simultaneously a commodity, a measure of global risk, a haven from debased currencies and inflation, an instruement of foreign policy and an arena for domestic ideological struggle.
Explanations of oil price movements well after the fact are, at best, rationalizations or partial and ideologically tainted reviews. There is some little truth in every explanation and no big truth in any one explanation.

Apr 06 03:02 PM

[guymar:]

Just end physical de-coupling on the Futures Exchanges and return to a prior 2001 situation, oil and commodities speculation will exit the scene just as quietly as they creeped in. But not to worry, the remainder of it will be killed by deflation anyway. The larger question is dependency and not on the level of drilling/refining, but on the level of distribution. We can switch very quickly to other energy sources but can we distribute them? And I defy any economist, dear Mr. Korzenik, to come up with a model that discounts the effect of a politically entrenched distribution oligarchy with a large impact on political opinion in price elasticity. A wager perhaps?

Apr 07 08:23 AM

[guymar:]

Sorry for the typo, the last phrase should read impact on PUBLIC opinion, not political, my mistake ....

On Apr 07 08:23 AM guymar wrote:

> Just end physical de-coupling on the Futures Exchanges and return
> to a prior 2001 situation, oil and commodities speculation will exit
> the scene just as quietly as they creeped in. But not to worry, the
> remainder of it will be killed by deflation anyway. The larger question
> is dependency and not on the level of drilling/refining, but on the
> level of distribution. We can switch very quickly to other energy
> sources but can we distribute them? And I defy any economist, dear
> Mr. Korzenik, to come up with a model that discounts the effect of
> a politically entrenched distribution oligarchy with a large impact
> on political opinion in price elasticity. A wager perhaps?

Apr 07 08:25 AM