Charles Engel on the oil bubble

Charles Engel, Menzie’s colleague at the University of Wisconsin and my long-time personal friend, enters the world of blogging with some thoughts on whether we’re seeing a bubble in oil prices.

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18 thoughts on “Charles Engel on the oil bubble

  1. M1EK

    I tried to comment there and lost the text due to forgetting to include the dash at the end of the CAPTCHA. Argh.
    Again, in order to accept his position, you have to assume that there’s a lot of pumping capacity lying around today that’s not being used (like there was in the 1970s when OPEC succeeded in driving up the price so high). That does not appear to be the case today – the only major producer even claiming they could pump more are the Saudis, and there’s some strong evidence they’re being less than trutful (unless your idea of the ‘good stuff’ is the high-sulfur variety).

  2. spencer

    I did not read the whole thing because I had too many problems with the way he started.
    For one thing the futures market is not a market estimate of where the price will be at some future data. Rather the spread between the spot and futures market is the price of hedging against a higher price in the future. The spread is a function of those who are willing to pay to avoid that risk and those who are willing to take the risk for a price. the spread is the price that clears the market for trading risk, not a market prediction of the price. Yes, market expectations about future prices influences the price of that risk, but it is just one influence.
    If you look at the long term record the futures market essentially forecast rising prices when spot prices are rising and falling prices when spot prices are falling. The futures market in oil has missed every significant trend change in oil prices over the last 30 or 40 years I have data on.
    His entire premise that prices would have gone to over $100 several years is just plain wrong.

  3. wogie

    The idea it might be harder to get the oil out of the ground gets short attention. In the case of the Saudis that may be the case. While not up to date Oil Drum piece shows that between early 2005 and early 2007 oil rigs in country jumped from about 18 to more than 55, more than 200% invrease — and production still dropped. And, of course, we know North Sea, Alaskan, and Mexican fields prodution has peaked, as well

  4. Sebastian

    Engel said: “Second, low real interest rates keep the price high. That is standard economic theory. An easy way to understand this is that when the real interest rate is low, producers have less incentive to take oil out of the ground. If they sell the oil today, what will they do with the money they earn? Theyll get a low rate of return, so they might as well keep the oil in the ground and sell it later. This restricts current supply and drives the price up today. Real interest rates have been low for a variety of reasons that have been widely discussed U.S. monetary policy, a world saving glut, etc.”
    If you look at real interest rates (I’m comparing the rate on 10-year Treasuries and CPI-U) they’re still just a bit negative (inflation higher than return) at the moment. The last time this happened was in the 1970’s, but it wasn’t until after they crossed back positive (around 1980) that oil prices finally began to peak.
    Without making any other comparisons between the two time-periods, I’m wondering if we can make a reasonable assumption that oil is going to continue to rise for a bit longer, at least until real rates are positive again
    Sebastian

  5. jjr

    Engel’s piece is useful in a simplistic academic way, which is to say not at all in the real world. In the real world the executives making decisions in the oil industry have a lifetime of boom-to-bust experiences that color their decision making. In the real world, global data on supply and demand is imprecise and often wrong. In the real world, taxation is a factor that gets considered. I mentioned some of these over at Roubini’s blog in more depth.

    I also have some belief that oil and other hard commodities have become stores of wealth. To the extent that interest rates have driven down the exchange rate of the dollar, interest rates are a factor in this. If I was managing a sovereign wealth fund, I’d much rather store my attained wealth in a hard asset like oil than a fiat currency like the dollar. I’m not, but realistically some of them are thinking along these lines.

  6. DickF

    Spencer,
    I agree. Also when he states that oil is produced based on the return the producer gets on the dollar received left me cold. That is like saying airplane routes are only increased when the interest rate allows the airline industry a greater return on its money. Or Microsoft only produces when the interest rate is high.
    I think jjr hits it when he says, Engel’s piece is useful in a simplistic academic way, which is to say not at all in the real world.
    The oil gold ration is about 7:1 so there is a supply/demand component in the oil price (normal runs 10-12:1), but even at that it is easy to see inflation is a huge protion of the price of oil.
    But that said I believe that the price of oil has run past its equilibrium point and in the fall there will be a huge drop in price. But that is dependent on the amount of inflation the FED pumps into the system. Gold back above $100 and all bets are off.

  7. me

    What spencer and jjr said plus what wogie said:
    “The idea it might be harder to get the oil out of the ground gets short attention.”
    Brazil could be drilling 4-5 miles down.
    “Brazil’s state-controlled oil company, leased about 80 percent of the world’s deepest-drilling offshore rigs to explore prospects including the Western Hemisphere’s biggest discovery in decades.
    Petrobras, as the Rio de Janeiro-based company is known, is hiring rigs that can drill in at least 3,000 meters (9,800 feet) of water, Chief Executive Officer Jose Sergio Gabrielli said in an interview last week. The world has 21 such vessels, according to Rigzone.com, which tracks the offshore drilling industry.”
    http://seekingalpha.com/article/77511-petrobras-is-hoarding-the-world-s-deep-sea-drillers

  8. Amar Harolikar

    So how much of the commodity price rise is ‘real’ and how much is speculative. Here are some rumblings across the globe that I came across by :-
    – As per Commodity Futures Trading Commission, which regulates commodity futures in US speculators account for around 37 percent of outstanding contracts in U.S. crude oil.
    – There is a research carried out by a researcher in Korea very recently where the researcher has tried to approximate the % contribution of key factors (speculation, demand-supply, dollar weakness and geopolitical reasons) in the commodity price rise. It seems for oil and wheat more than 40% of the price rice has been contributed by speculative interests and another approx 40% by demand-supply reasons
    – Oil ministers from nearly all the OPEC countries from Saudi (the biggest) to Qatar (smallest producer) are vociferous in their statements that there is no shortage of oil, that the inventories are piling up and the price rise has been driven by speculative interests. Is anybody listening to them ?
    Amar Harolikar
    http://taxationindia.blogspot.com/

  9. DickF

    Can you define speculation? If you mean someone who wants to make money off of arbatrage there is nothing wrong with that. In a market economy these are the people who return the markets to equilibrium. Speculators get a bad rap when they should be looked upon as the ones who return sanity to insane markets.

  10. don

    I found Engel’s piece useless. His conclusion, that either markets have been fooled over and over or that oil prices are in a bubble, goes far beyond what can be reasonably supported by his scanty analysis. Sounds similar to the proof that manned flight is impossible, based on the finding that no lighter-than-air materials can have the strength needed to support the weight of a human being. For example, what if markets learn over a period of time, rather than being informed suddenly? Surely, it would take some time for a new realization to dawn. Who’s to say the one that’s dawning now has progressed too slowly? Could any noninstantaneous learning be termed as the market “being fooled over and over?”

  11. E. Poole

    Nice well-argued piece.

    Expansive monetary and fiscal policies in the late 1960s/early 1970s appear to have contributed substantially to increases in real oil prices. The critical intermediate variable is the expected real interest rate which was low or negative for many years during that period.

    In Engel’s explanation, the real interest rate represents the opportunity cost of oil inventories. In other models, lower real interest rates would increase output and the demand for oil through investment or increases in the labour supply, especially if the rate shocks are not fully anticipated.

    Those looking for a tight correspondance to current reality may not find one. The real costs of borrowing capital have gone up. (See the balloon that some US banker floated on the weekend about re-pricing the LBO/privatization of Canadian telecomm giant BCE lower than the C$42.75/share agreed to last summer.)

    If unexpected higher real energy costs are hinting at the increasing obsolescence of the current capital stock, increased expectations of slower growth could easily drive real borrowing costs higher.

    There is a more mundane explanation. Markets have generally been awful at forecasting oil price demand elasticities in this decade and have given up over analyzing demand on the assumption of significant inertia in global demand due to robust emerging economy demand. Anything else in the larger economy is treated as spurious noise in this radical decoupling view.

    FWIW, I’m betting that the price of oil declines between now and October 2008 and natural gas prices will increase in the same time period. Oil and gas stock markets look like they are just starting to heat up. Refineries will drag down integrated company earnings.

  12. DickF

    Don,
    No, not only those speculators who make a profit but also those who lose. All speculators work at the margin and so are the ones who actually set the prices. Speculation is important for setting prices both on the up side, speculating long, and on the down side, speculating short. While these speculators “war” against one another it is this conflict that actually sets the price; one side must win, the other lose.
    This is different from the producer who is hedging to cover his production cost plus profit.

  13. DickF

    Don,
    Think about it. First, if the speculator loses money the market proves him wrong and so others see that the market cannot go any higher or lower; the boundry is set. Second, for every speculator in one direction there must be a speculator in the other direction. One’s loss is the others gain and once again the market defines boundries.
    Speculators only distort the market when the government and/or central planners prop them up or take them down destroying their arbitrage function.
    One of the most serious failures in economic education today is the failure to teach the important role of the entrepreneur and the speculator. They are usually taught as evil elements of the system because they seek to make a profit, but in truth their profit is our gain because they bring market disequilibrium back into balance. This is a function that the government can never do. The government and the central planners only create disequilibrium because by definition their intervention goes against the wishes of the consumer.
    One of the most serious problems contributing to the Great Depression was the government destroying the role of the entrepreneur and speculator.

  14. DickF

    Josh,
    Great article! It goes along with something I posted about the 1996 deflation creating a crisis in infrastructure in oil producing equipment. The whole world – with the exception of the US, thank you Democrat congress – is expanding oil production as fast as it can yet there are still demand problems.

  15. gordon

    The price of an index grade like West Texas Intermediate or Brent or others isn’t “the price of oil”. In fact, the markets for these index grades are relatively thin. It would be nice to know what the contract prices for oil actually shipped from the Middle East, Nigeria, Venezuela etc. really are before engaging in speculative explanations of numbers which may not be what is actually being paid.

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