Oil prices: a classic bubble economy?

Oil bubble

The price of oil has quadrupled since 2003. If this dramatic rise were the result of speculation in a bubble economy and not the normal forces of supply and demand, how would you go about proving it?

Try using some well known concepts from statistical physics and complexity theory, says our old friend Didier Sornette at the Swiss Federal Institute of Technology in Zurich.

For economists, the term bubble refers to a situation in which excessive expectations of future price increases cause prices to rise above what can justified by a fundamental valuation.

One of the signatures of such a bubble is a faster-than-exponential growth in prices, something that has been seen in several recent bubbles such as the dotcom boom that busted in 2000, the US house price surge that peaked in 2006 and the sub-prime market which collapsed in 2007.

What creates faster than exponential growth? One possibility is positive feedback mechanisms which reinforce unsustainable prices rises.

So Sornette’s analysis involves identifying the signature of faster-than-exponential growth, which is relatively easy to spot, and then identifying the positive feedback mechanisms that may have caused it. These, he says, are:

(1) Protective hedging against future oil price increases and a weakening dollar whose anticipations amplify hedging in a positive self-reinforcing loop

(2) Search for a new high return investment, following the collapse of real-estate, the securitization disaster and poor yields of equities, whose expectations endorsed by a growing pool of hedge, pension and sovereign funds will transform it in a selffulfilling prophecy;

(3) The recent development since 2006 of deregulated oil future trading, allowing spot oil price to be actually more and more determined by speculative
future markets and thus more and more decoupled from genuine supply-demand equilibrium.

Sornette says this “provides evidence that the recent oil price run-up has been amplified by speculative behavior of the type found during a bubble-like expansion.”

He may well be right but he fails to nail the argument in this paper.

There is another way in which faster-than-exponential price rises can occur and that’s from a faster-than-exponential rise in demand. What Sornette fails to show is that the recent price rises cannot be explained by a faster-than-exponential rise in demand from economies such as China and India.

That’s not beyond the realms of possibility but Sornette seems to ignore it. (Of course, the Chinese and Indian economies may be part of their own larger bubble but that’s another issue).

Sornette says oil price rises may be the result of speculation. Then again, they may not.

Ref: arxiv.org/abs/0806.1170: The 2006-2008 Oil Bubble and Beyond

4 Responses to “Oil prices: a classic bubble economy?”

  1. Tonis Vaga says:

    Oil may continue to appreciate over the long term as global production peaks while demand continues to grow. However, if Sornette is correct, and the run up in oil prices over the past few years has also been fueled by significant speculative demand, then there is a growing chance of an abrupt break in prices to lower levels. As Sornette states: “the bubble is close to a local peak (and actually may have already reached it).” Let’s hope that Sornette is correct in the near term to give us more time to prepare for growing long term energy demand.

  2. Brad says:

    There is no economic analysis to explain why the rise in oil prices is happening. the reason oil prices are so high is because the people in the middle east hate america. bottom line. they dont want us over there. they want to keep fighting for no reason. i say we leave them alone, let them kill each other (there will be less!!), and drill for oil ourselves. if we do happen to come across oil fields like in the middle east. we can undercut thier prices and help the rest of the world out instead of widdling down their economies every day. the oil owners are laughing all the way to the bank about how stupid we all are for paying these outrageous prices. finding our own fields would be a swift kick in the nuts to the people who are, most-likely, funding the war against us. WE ARE PAYING THEM TO FIGHT US!!!

    We need a president who doesnt owe 150 diff. people diff. things as soon as they get in office. We need a pres. who will stand for what America was founded for in the first place. Freedom from the tyranny and control of other countries. And whats happening right now? Gas prices are putting a cap on the developement of our economy. We will not be America again until we rely on ourselves and not imports from everywhere else.

    And to these big businesses that outsource all of thier work. QUIT!!! You are only giving away American jobs!! When people used to have morals, you found a company, and helped out Americans by giving them jobs, which in turn helped our own economy advance. Well, nowadays, when people found a company, they try to get the cheapest work done that they can so they outsource. Which gives jobs to people in other countries, stimulating thier economies and making ours rely more on importing goods that are cheaply made and poor quality.

    This country needs a moral overhaul and the people with power need a history lesson about the founding fathers and the dream that this country was.

  3. Enginerd says:

    His math predicts a critical point (I’m assuming that means peak of bubble) of anywhere from now until July ‘09. So we may have a long time to wait to find out if it was a bubble or not. This is usually the case.

  4. Dan says:

    It’s really simple.
    Worldwide production is flat, worldwide exports are declining, and supply chains are getting longer so more oil is in transit.

    People will not use less petroleum products unless they cannot afford to (what price of gasoline would it take to push you to biking or using mass transit?) so demand is highly inelastic and any drop in available supply requires dramatic price increases.

    On the down side, once people stop using petroleum products it takes quite a while for them to shift back, so a great enough drop in demand could cause prices to drop just as quickly as they rose in the first place.

    Boom and Bust, repeat as possible.