PK on the Existence of an Oil Bubble
More on oil and speculation
One of the things I find puzzling about the whole oil market discussion is how complicated people seem to make it. They get all wrapped up in stuff about forward markets, hedge funds, etc., and lose sight of the fundamental fact that there are only two things you can do with the world’s oil production: consume it, or store it.
Here’s my picture:
It’s not complicated
If the price is above the level at which the demand from end-users is equal to production, there’s an excess supply — and that supply has to be going into inventories. End of story. If oil isn’t building up in inventories, there can’t be a bubble in the spot price.
Now it’s true that oil supply responds very little to price, and that empirical estimates of the short-run price elasticity of demand, like this one, suggest that it’s low — say -.06. But even so, the math of a sustained, large bubble quickly becomes daunting. Say the demand elasticity is -.06, and that you believe that the current price is 40% above the level at which end-use demand equals supply. Then you have to believe that 2 million barrels a day is disappearing into secret hoards somewhere — secret, because it’s not showing up in the OECD inventory data. That’s a lot of oil. And bear in mind that people have been claiming that there’s an oil bubble for years.
So my challenge to people who say there’s an oil bubble is this: let’s get physical. Tell me where you think the excess supply of crude is going.
I tend to believe high oil prices are more of a long term trend than a bubble. I have a very small prior on this though, as I have not researched it much at all. I tend to agree with PK’s suspicion here, but I would counter that if enough of the oil is in places where drillers are not afraid to store it in its natural setting, then it may not be showing up on the charts. That is, if the cost of storage once pumped is greater than the expected cost of risk exposure to the drillers as well as expected movements in the cost of drilling, then drilling more slowly may be the answer to the excess supply problem PK notes. The excess supply may be in the production capacity and not the actual production volumes.
It is late, and I am tired; do not be surprised if I have made and missed a glaring mistake.
