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Correction to This Article
An earlier version of this column mistakenly said that oil prices are "inelastic." Demand for oil is "inelastic."

Is There An Oil 'Bubble'?

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By Robert J. Samuelson
Wednesday, July 26, 2006

Could there be an oil "bubble''? Well, yes. In early 2002 oil sold for roughly $20 a barrel; now it's close to $75. The main cause lies in tightening supply and demand -- and the fact that supply (as the present Middle East fighting reminds us) could be interrupted at any time. Old-fashioned speculation may also have played a role, and that raises the possibility of a bubble. But any bubble would be a peculiar beast, and if it burst and prices dropped significantly, we shouldn't delude ourselves into thinking that this might signal a new era of comfortable abundance. It wouldn't.

In financial bubbles, prices become disconnected from "fundamentals." At the height of the tech bubble, stocks of dot-com companies with no profits (and little prospect for them) sold at fabulous prices. By contrast, oil prices aren't unhinged from "fundamentals." Despite all the griping, gasoline is still affordable. Even at $3 a gallon, it costs Americans only about 4 percent of their disposable income, reports economist Nigel Gault of Global Insight. The same is true globally. At $70 a barrel, global crude sales would total about $2.2 trillion annually; that's still a tiny share of the $50 trillion world economy.

Indeed, it is precisely because people and companies need oil so desperately -- it's essential for almost everything they do -- that any possible scarcity raises prices sharply. In economics jargon, demand is "inelastic." A big jump in prices dampens demand only slightly. Similarly, a big decline in prices increases it only slightly.

For decades, crude was in surplus. In 1985, for example, the world used 60 million barrels daily (mbd) of oil, while countries could produce about 70 mbd. Refineries were also in surplus; in 1985, U.S. refineries operated at 78 percent of capacity. Loss of crude supplies or refineries didn't create scarcities. "Historically, when something went wrong -- and something was always going wrong, a pipeline outage or refinery accident -- the problem was made up somewhere else," says economist Lawrence Goldstein of the Petroleum Industry Research Foundation, an industry think tank. Prices moved by a few pennies or dimes. Hardly anyone noticed.

Now demand is about 85 mbd, and extra capacity is 1 to 2 mbd. Even this surplus is more apparent than real, notes Goldstein. It consists mainly of high-sulfur ("sour'') oil, for which there is scant refining capacity. All refineries are stretched tight. The U.S. operating rate typically exceeds 90 percent of capacity -- a margin needed for maintenance.

Low prices and miscalculation explain the turnaround. From 1985 to 1999, crude prices averaged $18 a barrel. Investment in expensive oil fields and new refineries became unprofitable. Companies cut budgets. They fired petroleum engineers and merged. Exxon bought Mobil; Chevron absorbed Texaco. Meanwhile, almost everyone underestimated oil demand. Driven by China, it grew much faster after 2000 than before.

So prices had to rise. Otherwise, demand might have exceeded supply. But did they have to rise from $20 to $70 a barrel? Here's where speculation may have contributed.

"Speculation" has a bad image. It suggests financial sharpies plundering everyone else. The reality is often the opposite: financial innocents following the latest fad to ruin. That happened with tech stocks. The oil picture is murkier. The big "speculators" are institutional investors -- pension funds, hedge funds (pools of loosely regulated funds) and investment banks. They have purchased oil futures contracts and, in effect, bet that prices six months or a year out will exceed present prices. Since 2002, investment in futures contracts may have quintupled to more than $100 billion, estimates energy economist Philip Verleger Jr.

This may have raised present (or "spot'') oil prices, argues a staff report from the Senate Permanent Subcommittee on Investigations. As investors pour money into futures contracts, futures prices rise. Since late 2004 they have usually exceeded spot prices. On a recent day, the spot price was $74.60 and the futures price for December was $2 higher. This creates an incentive for companies to put more oil into storage ("inventories''), the report says, because it's more profitable to sell oil in the future than today. Oil inventories for industrial countries "are at a 20-year high." Spot prices rise because there's less oil on the market.

It's unclear how much this sort of speculation has increased prices, if at all. The report mentions estimates ranging from $7 to $30 a barrel. In theory, the process could feed on itself and create a huge bubble. The more speculators bought futures, the more oil would go into storage -- and the more spot prices would rise. At some point, the bubble would burst. Storage would be filled. Unexpected increases in supply or shortfalls in demand could put huge downward pressures on prices, because sellers would need to sell, and (again) demand is inelastic. Some experts, including Verleger, think this possible.

Whatever happens, we should avoid the easy conclusion that speculators have artificially increased oil prices. In truth, they are speculating against real risks -- the risk that oil from the Persian Gulf could be cut off; that hurricanes in the Gulf of Mexico could damage U.S. oil rigs and refineries; that political events elsewhere (in Russia, Nigeria, Venezuela) could curtail supplies. High prices reflect genuine uncertainties.

Oil is essential and insecure. A sensible country would minimize this insecurity by economizing on oil's use (through taxes and tougher fuel regulations) and developing its own resources. We should have redoubled our efforts years ago; we should do so now.

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