The Housing Chronicles Blog: The proof is in: speculation caused the oil bubble

Sunday, August 10, 2008

The proof is in: speculation caused the oil bubble

Ever since oil prices began their steep pricing rise earlier this year, we had pundits dismissing talk about overt speculation in oil futures for the increases. They pointed to static production, rising demand by emerging economies and political instability in countries with large oil exports, but they never really explained why a slow yet steady rise in demand would result in a spike in such a short time. People paid higher prices because they had little choice in the short run, but over time began to make adjustments that led to slowing demand that would eventually impact prices, but certainly not lead to the price drops we've seen in recent weeks.

So why have they fallen so quickly? An article in the UK's Daily Telegraph takes it on:

The market's conviction that oil prices were set on an unstoppable upswing was underpinned by a set of mantras to be chanted daily before breakfast by anyone hoping to make money by following the crowd: insatiable demand from China; indolent Opec sheikhs unwilling to open the supply taps; that nasty Vladimir Putin playing political hardball with Russia's oil and gas resources; those mad Iranian mullahs hell-bent on nuclear conflict; and beyond all these, the looming threat of "peak oil", the inevitable moment when Mother Earth's carbon-fuel gauge starts pointing towards empty.

One way or another, said the fundamentalists, the only destination for oil prices in the medium term was somewhere north of $200 a barrel. And hooray to that, chorused the green lobby, because it may be the only thing that will ever make us wake up to the need to stop cooking the planet with carbon emissions...

Now the psychological tide seems to be turning. On the supply side, Saudi Arabia, the dominant member of Opec, is now signalling greater willingness to open the oil taps. When the princes of the desert made a rather smaller gesture of willingness in that direction in June, the market took no notice and prices marched on. But in the new mood, any hint of an increase in Saudi supply is a reason to mark down prices.

As for the Russians and the Iranians, the pundits have remembered that even the most externally truculent or internally turbulent of energy-exporting nations can feed its people at home only by selling its natural resources abroad, so must ultimately stay on good terms with its customers.

And meanwhile, five years of rising oil prices have provoked a wave of investment in new drilling and refinery capacity - including the opening up of inaccessible oil sources that no one wanted to tackle when prices were low. Whether it is deep under the Arctic ice-cap or soaked into the tar-sands of northern Alberta, there turns out to be quite a lot more oil waiting to be exploited before we really approach the peak-oil apocalypse. More than that, high oil prices have encouraged rapid development of such alternative energy sources as wind and solar power, and more efficient engine and heating technologies.

On the demand side, a shuddering deceleration in economic activity across the industrialised world is starting to take pressure away. Many economists think the downturn will be deep and painful, and Opec (whose predictions are naturally at the low end of the range) thinks demand for its output could be lower in the early part of the next decade than it was in 2006...

There is a long-running argument as to just what proportion of any commodity price movement can be traced to speculative activity by hedge funds and others, and what proportion to physical demand. But when the oil price swings up or down by $5 or more in a single day, you may be sure that the fluctuation is not being caused by a sheikh on one end of the line arguing with the manager of your local petrol station on the other: it is the financial parasites in between who are moving the market.

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