Does the high oil price reflect a bubble?

Paul Krugman writes (and here):

The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding – an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.

But it hasn’t happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels.

I’ve never been one to push the bubble hypothesis to explain the high price of oil but I find this an unusual argument to make against bubbles.  Isn’t it easy enough to argue that the relevant hoarding is of oil in the ground rather than oil in strategic reserves or panic stockpiles?  We have lots of state-owned oil companies and maybe their way of speculating is simply to remain sluggish in their exploration and extraction activities, at least for the time being.

I think of a bubble as a market price which is above the fundamental value of the asset, largely for psychological reasons.  But with a commodity like oil the fundamental value of the asset depends on the marginal unit and thus how much oil is supplied.  Fundamental value, at least at the margin, adjusts to the price and in that sense the bubble hypothesis can seem tautologically false if we apply the traditional definition of a bubble. 

The key question, in my view, is how much more the oil-producing nations could bring to the market if a) their state-owned oil companies were not incompetent, and b) they did not tolerate this incompetence as an implicit form of speculation and collusion.  I will not offer an estimate here (I genuinely don’t have one) but b) does leave some room for bubbly-like phenomena, whether or not stockpiles of pumped oil are high.  Note that in b) collusion and speculation work together and a) tosses incompetence into the mix.  The whole foul brew is probably easier to sustain in times of rising demand and thus oil price explanations are not going to be very simple, or easily separable, by the nature of the problem.

Addendum: Read Arnold Kling, here and here.


A number of people made this argument on Krugman's page. But this argument proves too much: we could never distinguish between genuine scarcity and this expanded concept of hoarding.

National oil companies have a very different set of priorities to those of the private companies. And the NOCs control about 90% of world oil production.

I think the repeated call that oil is in a "bubble" or that "speculators are messing up the market" is to provide for some illusion that prices will drop. As well as to provide an excuse for why all these magical solutions like, oh, "shale oil" or "tar sands" aren't springing into production.

To Michael Webster:

Certainly, a distinction can be drawn between "real scarcity" and what you call an expanded concept of hoarding. That distinction is obvious right now, as investment flows into more expensive means of production (oil sands, shale, CTL technologies, deepwater, steam-injection enhanced recovery in marginal fields, etc.) are far slower than one might expect with barrel prices at $125.

The problem is that speculators, or NOCs indulging in surreptititious speculation through production foot-dragging, have an excellent point. Demand growth in enormous developing economies, as well as a security premium dictated by political instability in key producing regions, suggest that the price of oil has not yet found its zenith. It will be difficult to know when exactly that zenith is imminent, but it is not hard to know that it is not imminent yet. Add to this the lengthy lead-time of capital investment in production (especially the more exotic and expensive models), and you have a situation where extremely high upside potential will be required to offset extremely high perceived risk.

Bottom line: it may be a bubble, but if it is, it has a lot more inflating to do before it does anything else.

Aren't these contracts cash settlement anyway with OPEC following the price set in the futures market? that way there's no need for taking delivery and needing to store what you buy..

"We have lots of state-owned oil companies and maybe their way of speculating is simply to remain sluggish in their exploration and extraction activities(...)". This actually happened in Brazil in the 70's, for ideological purposes though. Giuseppe Bacoccoli, who worked for 32 years on the exploration area of Petrobras - the brazilian state-owned oil company - has been saying that when the company knew there was a place with no probability of having oil, it auctioned it for the private sector. So, doing this, the sate would have the monopoly of exploration and would also earn some money from the auciotns.

Superimpose the NASDAQ index over the crude oil price, with NASDAQ in March 2000 coinciding with oil
in April 2008. There is a 92% correlation. Do all bubbles look alike? The NASDAQ bubble had
nothing to do with inventories of, so why do need inventories of oil to explain a bubble?
Oil is an asset as well as a consumption good (like housing that way). Its price can rise if
future supply and demand prospects suggest that future prices will be so high that it pays to buy rights
to oil now. (Hotelling and all that.)

It is odd that Krugman is obsessed with inventories. Some years ago, he presented a model of OPEC with
multiple equilibria: a high price and low price equilibria, made possible by a backward bending supply
curve. The supply curve turns backward for a while because as prices rise, oil exporters want to
invest more, and they invest by keeping oil in the ground. Put another way, they are targeting total
revenue, not profits. So, as you said, one way to build inventories, consistent with the old but not new
Krugman, is to pump less oil.

"The NASDAQ bubble had
nothing to do with inventories of, so why do need inventories of oil to explain a bubble?"

Because there is a cash to futures relationship for Oil, you can deliver actual Crude Oil against a futures contract for Oil. And the cash market is ruled by fundamentals the price is set at where the market clears supply and demand. There is no such relationship for

More likely a case of extreme competence. Produce more and see profits fall or produce less and make it up in price. Particularly when you are already making more money than you know what to do with. Investing in future inventory may be the best investment they can make, and likely is.

Certainly the so-called Big Oil companies of the west were better at the pursuit of yearly and quarterly growth (sales and earnings). Just look at their fields - most boomed and are in decline now. The NOCs lurch from good production to weak production and thus over the longer term their production can seem much flatter.

I think we have seen a paradigm shift. There are two ways to make profit as an oil producer - pump-more/sell-more and raise-the-prices.
The paradigm shift is that there is now no player in the market with enough serious excess capacity to bring the market to surplus and those reputed to have "some" excess capacity realize that restraint will make them a lot of money.

Thus OPEC has lost one of its two teeth - flood the market to reduce prices.
They can still hold back product.

Perhaps this is even worldwide collusion. Perhaps it is the more subtle signaling. The crude oil producers all just signaled to each other by all the talk of "the easy oil has been found" only difficult oil remains to be found...
and they all picked up on the tune...

Certainly oil sands and tars in Canada and Venezuela are more expensive to produce than other types of crude oil. If some supplier could flood the market they could drive these operations perhaps to bankruptcy. Deep water drilling (like Jack 2 in the Gulf of Mexico) is also very expensive.

So at this point which producer would venture to bring the prices down?

Or perhaps this is about as much as we will ever be pumping on a daily basis and everybody's hands are tied. Certainly if you look at the data most of the growth these past couple years has been biofuels and the capture and selling of the heavy gases known as NGL - Natural Gas Liquids. [ethane, propane and butane]

No discussion of the possibility that we may be running out of the easy-to-find, easy-to-drill oil?
@Nick: Oil sands are a little silly. Physically, what they're getting now is the most available -- its the part fo the seam that is above ground. If they want to continue producing, they will need to follow the seam underground, which will obviously entail more cost. Add to that the fact that this process consumes enormous amounts of water and natural gas, and this looks worse all the time.
In terms of production, if these optimistic predictions bear out, Canadian oil sands will provide roughly 3% of world needs. It's not clear that the oil sands are now net energy positive, and less so that they will be in the future (when they have to dig deeper into the ground to follow the oil sand seam). More on oils ands here:
Finally, in the meantime, lots of other oil sources are drying up:
I now that "peak oil" isn't a popular phrase in these parts, and I personally believe we won't end up in a Kunstlerian nightmare ( -- but if we keep ignoring the problem, we might.

PDVSA , venezuelan state owned company, fired 20,000 workers in 2002.2/3 of their workforce.The production fell to less tan 2 m b/day.Know its said they have 100.000 workers.Exreme competence.Read the mexican newspaper or see mexican tv and you will know about the exteme competence of Pemex in briberies , corruption and waste

well there's your hoarding...

Pat L:It's clear that there has been an outward shift in the demand curve due to accelerating growth in China and other developing nations.

Do you have good evidence for this, or are you just repeating what many others have been repeating? The most credible sources I've read say that demand has not departed from its long-term global trend: higher demand growth for commodities including oil in Asia has been offset by lower demand growth for commodities including oil in the U.S. and Europe.

o you have good evidence for this, or are you just repeating what many others have been repeating? The most credible sources I've read say that demand has not departed from its long-term global trend: higher demand growth for commodities including oil in Asia has been offset by lower demand growth for commodities including oil in the U.S. and Europe.

Just look at the EIA's historical figures (.xls) for worldwide petroleum consumption. They go up year after year, even as prices rise. So the demand curve for the world is shifting to the right.

So why are they leaving it in the ground this time, but didn't in past "bubbles"? Surely, the technology for not-drilling was at least advanced enough in the 1970s. Some structural change? Offshore refining? Different tax consequences?

How about a nasty war between Iran and Iraq that meant both sides needed cash NOW, and couldn't afford to stockpile any oil?

I think it has more to do with the value of the falling dollar. When the Fed decides to defend the dollar, as they should, I believe we'll see the price of oil come down. What we are seeing is a contraction of the dollar bubble.

I don't have data about hoarding or speculation ...
but I used to talk a lot with petroleum geologists worldwide, probably helping sell $500M of computers to them in the 1990s.

They were buying because:

a) Good oilfields were getting harder to find, so they needed better seismic processing.

b) They were trying to extract larger percentages of oil from each field, hence wanted much better reservoir modeling.

c) i.e., the EROI was going down, see for example, Charlie Hall's Balloon Chart (in the middle of long post)
1930s oil in US: ~100:1 EROI
1970s oil: ~30:1
today: ~10:1

a) Recall that US oil production peaked in 1970, despite the US having great technology and lots of capital. It didn't peak because people were hoarding it.

b) At some point in a big reservoir's life, people may have to inject CO2 or lots of water to keep it flowing, not cheap. EROI down.

c) Finally, if a well is *already* flowing at an optimal rate, increasing the flow, or "overproducing" can actually damage it and reduce the total oil obtained.
Hence, people don't normally do that, but they might turn on wells that are sitting idle, of which there are few,, especially as even Saudi appears to be tapped out of such capacity.

d) And it takes time to find oil and develop the fields, and the big, wonderful fields (like Al Ghawar in S. A.) were found many decades ago.

e) A friend of ours used to be Chairman of Shell, and he has clear opinions on Peak Oil.

f) I've visited national oil folks in China, Saudi Arabia, Abu Dhabi, Dubai, Brazil, at least, and I thought they were pretty competent, although this was the engineering side.

Not all of the real world of oil is economics, at least some is geophysics, and it's pretty unforgiving.

John Mashey,

EROI is highly simplistic and misleading. If we had an energy source with an EROI of 2:1, but it could be extracted with very little labor and capital, it would make a quite fine energy source. Indeed, the conversion of motion into electricity, fuel into motion, etc. often has an EROI of less than 2 (i.e. an efficiency of less than 50%) and is nevertheless an economical source of power. It's no different for converting power from nature in the first place -- it's nice to have more efficient conversion, all other things being equal, but the efficiency of the conversion does not usually make a good proxy measure for its economic cost. One cannot escape the complicated questions of labor, capital, regulation, and monetary strategy in establishing energy supply curves. EROI might make a good proxy measure for a single kind of energy (e.g. oil) where technology is rather static, but I'm not sure this is the case with oil. I don't think it makes sense at all to compare the EROI of different kinds of energy that might have very different capital and labor costs. One has to do the hard work and try to measure the capital and labor costs.

I do find this quote from the linked article interesting, however:

the empirical record shows that the rate at which oil and gas is found has little to do with the rate of drilling

This is consistent with the monetary function of oil. Indeed, one should expect that, if geology and technology are neglected, there is some inverse correlation between the two. In times of inflation (that is, increase in supply of normal currencies beyond demand for those currencies) oil reserve owners want to boost reserves, and in times of deflation they want to deplete them, on top of taking a regular cash flow. Thus in times of inflation (as now and in the 1970s) we see relatively less drilling and more discovery, and in times of deflation (in the 1980s and 1990s for example) we saw less discovery and more drilling.

None of this is to say that geology is unimportant, but one misses the biggest piece of the price puzzle by failing to realize that oil, like gold and most other commodities, has monetary functions and responds to the monetary behavior of the normal government currencies.

Is it not a fact that if OPEC just produced more, which they are capable of doing, price would go down? I realize they are not keen on doing this, but destroying the economy of one of your largest customers is not in their long term interests.

how oil prices and gold prices relates?

The 'free market' is an illusion a very effective propaganda spewed across the globe extolling the precepts from the gospel of the "The Free Market" preached by the Economic ministers of the faith.

No more interpreting of illusion is necessary. It's now time for action!

Review my articles:
A Green Future for Our Nation
Benefits of Nationalized Oil Industry
Nationalize the Oil Companies
Economic Society


For a better understanding of what where facing.

It is now time to make certain that everyone understands the truth, solutions, and what will happen if we fail to act now.

Great article! Nice Comments!

I would like to link to this on one of my pages.

Great article! Nice Comments!

I would like to link to this on one of my pages.

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