Monday, March 10, 2008

Oil price speculation: is it rational investment or a bubble?

I've read recently that oil prices "now" are driven by "speculation" rather than "fundamentals". In other words, based on near term supply and demand curves, including our current recession, prices should be stable or dropping, not rising.

Yet rise they do.

In August of 2007 I'd thought that, absent any surprises, gas would hit $5/gallon in the midwest around 2011:

2011: The year American life changes (Aug 2007)

When will energy costs in general, and gasoline costs in particular, fundamentally change the way middle-class Americans live and work? We know gasoline prices will rise until something changes, even if the US never implements a carbon tax...

...I think a reasonable marker is the year that the baseline gasoline price hits $5 a gallon...

So when does it happen? I'll pull a number out of the air, extrapolating from my amateur chart and the Copernican Principle, and guess, even without a carbon tax or the complete collapse of Iraq, that it's 2011.

I'm in California today, and it's $4/gallon here in early 2008. My 2011 prediction for a change in American life is looking conservative.

So, is today's oil price rational speculation or bubbly speculation?

Well, I haven't read any good discussions of this lately, so I'll say something and hope Brad DeLong decides to clear things up

One way this speculation could be rational is of the people who are paid to know believe that peak oil is coming any time in the next 10-15 years -- especially given the current bleak options for alternative investments. For non-economist readers, here's why:

Gordon's Notes: Gasoline and the rule of 72 (May 2007)

... There's some smaller rate of return that would make retaining rather than selling petroleum products the right way to invest. This is what all the "peak oil" crowd get excited about; but the term is a bit misleading. It's not that oil production needs to peak, it's simply that demand has to persistently outstrip supply. Prices, of course, don't wait for demand to outstrip supply, they begin rising as soon as a demand/supply gap can be reasonably anticipated within the time frame of investment decisions (10 years roughly).

This, by the way, is a very good thing. It means that prices rise long before we run out of oil, giving everyone time to adapt and adjust.

I do wonder what the sober experts calculate. They can look at supply curves and demand curves and the available substitutions within the next decade. Do they see a significant supply/demand gap opening up? If the price of gas will be $7/gallon in six years (well within the lifespan of your next Ford F-250), is that enough of rate of return to justify holding products now?...

So here's my proposal for deciding if Peak Oil is on the way.

If the price of oil craters ($65) in the next 6 months then we're living in an energy bubble today and Peak Oil is more than 10-15 years away.

If the price of oil is above $105 a barrel in August of 2008 then Peak Oil is on the sooner rather than later, and the world I grew up in is shuffling away -- sooner than I'd expected.

So American Life may change in 2008 - not 2011.

No comments: