Is it “peak oil” or a speculative bubble? Neither, really

June 12, 2008

The article (2008-05-29) entitled “Is it “peak oil” or a speculative bubble? Neither, really” published in The Economist generated a robust on-line debate. It has been criticized for offering limited or overly simplistic scenarios: text book supply-demand [1] and its extreme variation peak oil and speculation. What about the weak US dollar some ask? See Lewis (2008-06-09) [4] What about the long list of factors listed in the most recent (2008-05-13) Oil Market Report of the International Energy Agency (IEA)? [2] And what about the role of the increasingly complex, volatile, unpredictable, interconnected and potentially destructive financial instruments that are now available to anyone with access to the Internet and capital? The bank of the world’s central banks is very concerned about public policy and their own role in managing (or not) these unmanageable instruments [3]. There was a time when economists could argue that the market would correct itself invisibly. Now all hands are wearing gloves, players are blindfolded and nothing is predictable and certainly not transparent.

The OMR claimed that the system is self-adjusting to bring the market into balance as the bull market driven by demand potential that has outstripped the slow supply growth – notably non-OPEC. Prices had to rise to choke off demand growth (IEA 2008-05-13:3). Events such as accidents, unplanned or unannounced maintenance and technical problems (Canada and the US:, labour strikes (UK), political unrest (Iran), guerrilla activity (Nigeria), wars and weather-related (Canada) affected supply losses. US companies, in particular, had very low refinery activity allegedly due to maintenance and unplanned outages by Shell, Chevron, ExxonMobil, Valero and BP refineries all during the same period. Lower discretionary driving, more fuel-efficient cars, higher volumes of ethanol blended into the gasoline pool cut into some demand in the US. However, the poorest Americans in rural areas have begun to choose fuel over food to keep mobile. The emergence of other markets, including China of course, as net gasoline importers will offset the so-called gasoline crack. The OMR also indicated that many nation states fearful of even higher prices and concerned about supply security, have been rebuilding their inventories at any cost since January 2008. This has increased competition for oil, bolstered demand and increased price pressures in 2008. While Saudi Arabia is blamed for not increasing oil production to balance the supply-demand equation, one wonders at the maintenance requirements claimed by American oil refineries that have contributed to supply problems and record profits for their companies sustained during the same period.

The rising price of oil has also been linked to the increasingly opaque and highly complex financial instruments, that oil executives, politicians, bankers or economists seem to be unable to fully understand and therefore control let alone manage. The unintended consequences of these financial instruments contributed to the mortgage meltdown and the credit crisis. The Bank for International Settlement report also warned of a major principal-agent problem as buyers of derivative and futures contracts lack skills and information required “to manage the risks inherent in the complex instruments they are buying?” (BIS 2007-05-29:9). The Economist‘s on-line forum [1] included a suggestion that technological and communications advances as a democratization of gambling have contributed to expanding the high-risk field of hedge funds (once only for the UHNW or oil industry elites) to include new, inexperienced and aggressive players who are unconcerned about unintended consequences. The increased competition and rates of return were already declining in 2006 leading to riskier and more aggressive hedging evident even in established banking institutions. Many neglect due diligence and are engaged in originating credit then transferring the risk exposure to others through securitisation or derivatives markets (BIS 2007-05-29:9).

The Bank for International Settlement report also revealed concerns over a year ago that short-term inflation could lead to long-term inflation due to high crude oil commodity prices (BIS 2007-05-29:59).

The Bank for International Settlements (BIS) report included “pivotal questions in terms of regulation of the oil commodities markets:

  1. What is the appropriate role of monetary and credit aggregates in the formulation of monetary policy?
  2. Assuming that occasional the credit-driven boom-bust cycles are possible, should the public sector seek to prevent the build-up of imbalances, or rather just clean up afterwards?

“Indeed, in the light of massive and ongoing structural changes, it is not hard to argue that our understanding of economic processes may even be less today than it was in the past. On the real side of the economy, a combination of technological progress and globalisation has revolutionised production. On the financial side, new players, new instruments and new attitudes have proven equally revolutionary. And on the monetary side, increasingly independent central banks have changed dramatically in terms of both how they act and how they communicate with the public. In the midst of all this change, could anyone seriously contend that it is business as usual? There is, moreover, a special uncertainty in the area of monetary policy. While the commitment of central bankers to the pursuit of price stability has never been stronger, the role played by money and credit is being increasingly debated, against the backdrop of the uncertainty about the inflation process referred to above. For some central banks, and indeed many leading academics, neither money nor credit is thought to play any useful role in the conduct of monetary policy. For others, in contrast, the too rapid growth of such aggregates could be either a harbinger of inflation or the sign of a financially driven boom-bust cycle with its own unwelcome characteristics. Against this background, neither central banks nor the markets are likely to be infallible in their judgments. This has important implications. The implication for markets is that they must continue to do their own independent thinking. Simply looking into the mirror of the central banks’ convictions could well prove a dangerous strategy. The implication for policymakers is that they should continue to work on improving the resilience of the system to inevitable but unexpected shocks (BIS 2007-05-29:145-150).”

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“In the light of history, it is both important and welcome that creditors and debtors increasingly realise the extent to which their fortunes are now intertwined.” (BIS 2007-05-29:9).


[1] Useful comment on The Economist article by ….Professor ???:

“I might also add, in response to QueenElisabeth, that there is no reason to think inventories would be accumulating unless the futures price rose significantly above the spot price, as it does in many textbook examples indicating one way in which arbitrage drives the futures price into equivalence with the spot price. Since the world doesn’t often behave like textbook examples, the spot price is tracking the futures price closely because every up tick in the futures price causes an almost immediate decrease in supply (which is the part of the process that should lead to inventory accumulation), and a simultaneous increase in demand as buyers seek to avoid higher prices in the future. It’s the increase in demand in response to higher expected future prices, expectations created entirely by goings on in the futures market, that is keeping inventories low. The lack if inventory buildups, in other words, is no evidence of all that futures prices aren’t playing a role in rising oil prices, unless you believe the last word in financial theory can be found in the “derivatives” chapter of a Money, Banking and Financial Institutions textbook. Aside from the usual suspects seeking to exhonerate themselves, which tends to lead one toward the opposite conclusion they would have us reach, the fact that oil prices have risen by about 30% since mid-March suggests that something far more than supply and demand for use are driving oil prices to their current record levels. The coincidence of trouble in the CDO market and rapidly rising commodity prices, as the flow of funds quickens into areas that are less risky and promise higher returns than mortgage backed securities, such as highly liquid commodity derivitives, strenghtens the case for the speculation hypothesis even more. I might also add that, as a financial economist, I typically teach that futures play an important role in facillitating a more efficient inter-temporal allocation of goods that look to become more or less scarce in the future. If futures prices have no effect on the price of the underlying commodity, and therefore on efficient resource allocation, we should have no reluctance about drastically curtailing the market since they would then serve no meaningful economic function that couldn’t just as well be served by less volatile financial instruments like forward contract. If they do effect current prices, as I believe they do, then strict prohibitions against their use for certain puposes should seem no more out of the ordinary, given the importance of oil in determining the structure of the international division of labor, than–for instance–legal arrangements preventing private individuals who have no legitimate reason to be in the market from purchasing opium or plutonium. You can’t have it both ways: either futures prices drive current prices and play an important role in determining the distribution of income and allocation of resources, among many other things, or they’re just financial instruments that serve as substitutes for betting on athletic contests or political elections. If the latter is the case, why not work toward their elimination entirely, and the return to non-standardized forward contracts, which were the main hedging vehicle in oil markets prior to 1983? Of course, the price of forward contracts would serve just as well as futures to indicate what the market thinks is going to happen in the future, and what it would therefore be most prudent to do in the present. The argument made here, and by economists like Paul Krugman, focus on the absence of inventory buildups as evidence that speculation in oil futures is playing an insignificant role in the current run-up in oil prices. One would expect to see rising inventories only if the futures prices rose significantly above the spot price. The spot price has been tracking futures prices closely, however. Why? To put it as simply as possible, a rise in the futures price not only decreases supply, as those who have the commodity seek to withhold it from the market in order to get a higher price in the future, but also an increase in demand, as buyers seek to avoid the higher price in the future by buying in the present. The effect on spot prices is unambiguous, but the effect on the quantity of oil bought and sold should roughly offset. As a result, the price rises, the amount of oil bought and sold remains roughly constant, and inventories neither accumulate nor de-accumulate. It’s insane to attribute a 30% rise in oil prices since mid-March to increased demand for use. Speculation is playing a huge part in this current price run up, as it is in the market for many commodities.”

[2]The Oil Market Report (OMR), published under the responsibility of the Executive Director and Secretariat of the International Energy Agency (IEA) provides an overview of the global oil market including a full disclosure of supply and demand.

[3] A useful explanation of the complexity and volatility of the world economy and the confusion surrounding analysis based on supply and demand, can be found in the 77th annual report of the Bank for International Settlements (BIS).

“[More] scepticism might be expressed about some of the purported benefits of having new players, new instruments and new business models, in particular the “originate and distribute” approach which has become so widespread. These developments have clear benefits, but they may also have side effects, with associated costs. In emerging market economies, the essential point is that liberalisation needs to be preceded by structural changes that will allow financial systems to remain resilient in the face of both domestic and external shocks. While much progress has been made, much more is still needed” (BIS 2007-05-29:151).

[4] “The weak dollar has had very little impact on the rapid rise in energy prices, Eric Rosengren, president of the Boston Federal Reserve Bank, said today. Although the decline in the dollar against other currencies has been a popular explanation for oil’s record run, Rosengren said that the data show the increases in oil prices have far outstripped the pace of the slide of the dollar in recent years.” (Boston Globe 2008-06-10)


Excerpt from “Challenges in formulating a policy response” in BIS report:

“There are a number of difficult and important questions facing central bankers, to which there are no agreed answers. A first issue has to do with the appropriate role of monetary and credit aggregates in the formulation of monetary policy. A second issue isclosely related: assuming that occasional credit-driven boom-bust cycles are possible, should the public sector seek to prevent thebuild-up of imbalances, or rather just clean up afterwards? Concerning the first issue, three schools of thought can be identified, each with at least some adherents in most central banks. A first school emphasises the short-run effects on inflation of gaps betweenaggregate demand and supply, with longer-run inflation trends being largely determined by expectations about such gaps. The role of money and credit is generally played down by this group. A second school attaches more importance to monetary developments in influencing longer-run trends in inflation. In practice, this would imply a continuing emphasis on the influence of demand-supply gaps on inflation, but with policy conclusions being systematically cross-checked against the monetary data. Finally, a third school of thought also attributes great importance to monetary, but above all credit, developments, albeit for a rather different reason. Adherents of this school become concerned when they see rapid growth of the aggregates along with rising asset prices, particularly if also associated with substantial and sustained deviations of spending patterns from traditional norms. They admit that the medium-term outcome could be rising inflation, but fear rather more that a boom-bust cycle might have significant economic costs, potentially including unwelcome deflation over a longer-term horizon. Both historical experience and intellectual fashion have played a role in these divergences. Adherents of the first school would contend that forecasts of inflation using gap methodology have proven reasonably accurate in many countries over many years. Their refusal to countenance any more formal role for money rests in part on the unsuccessful “monetarist” experiment of the 1970s, but also on the failure of econometric work to reveal a stable and causal relationship with inflation in their countries. Supporters of the second school of thought would note that their belief in the money-inflation nexus is deeply rooted in theory. Moreover, the Deutsche Bundesbank and the Swiss National Bank have been translating such beliefs into effective anti-inflationary policies for decades. The third school of thought has been influenced not just by pre-World War II business cycle theory but also by the wrenching historical experience of the booms and busts referred to earlier. While fashions come and go, it appears that the influence of the second and third schools has been growing. In recent years, a number of central banks, when raising policy rates, have cited concerns about very rapid growth in both credit and asset prices. A number of other central banks have announced their intention to lengthen their normal policy horizon, to allow them to better evaluate the full range of possible effects arising from their policies. Finally, almost everywhere, one hears reference being made to the “normalisation” of policy rates, a concept which logically implies that the appropriateness of policy cannot be judged on its short-run impact alone. Behind this shift in thinking have been a number of influences.”

“Forecasting inflation using traditional methodologies has become more difficult everywhere. Central banks are therefore looking for new guideposts, and these include the use of monetary and credit aggregates. Indeed, research in some central banks has recently identified what appears to be a reliable relationship between their monetary aggregates and inflation over long periods. Moreover, with the passage of time, new crises and the further analysis of old ones have provided empirical evidence to support the specific arguments for concern expressed by the third school. Finally, as evidence has accumulated that the global economy is characterised both by many imbalances and by a flatter short-run Phillips curve, the potential economic losses in a subsequent downturn have also been revised upwards. In sum, the possible implications of getting policy wrong have grown. All of these factors have helped to spur debate, and even sometimes to change minds. A second question, eliciting diverse answers, is how best to deal with what seems to be the natural procyclicality of the financial system. Should policy sometimes lean against an upturn, even in the absence of inflationary pressures? And if so, how? Should it rather lean primarily against the subsequent downturn, and if so how? Or, reflecting our lack of understanding, and the shortcomings of each of the individual policy instruments we currently possess, should it do both, using a number of policy instruments simultaneously? Short of serious re-regulation of financial markets, which would create many harmful inefficiencies over time, this more pragmatic approach to procyclicality in the financial system might have much to recommend it.”

“The principal argument for tightening monetary policy in the upswing is to moderate the excesses in economic and financial behaviour and, in so doing, contain the costs of the downturn. There are of course some significant practical difficulties with this approach. How do policymakers evaluate when imbalances are building up to such a size as to warrant action? What degree of tightening would be required to moderate market euphoria, and might it do serious harm to unaffected parts of the economy? These points have been made repeatedly, and validly, in connection with the hurdles that central bankers would face in targeting asset prices. But the suggestion being made here is different. It is rather to react when a number of indicators – not just asset prices but also credit growth and spending patterns – are simultaneously behaving in a manner that indicates increasing exposures. In principle, such a configuration of developments would be both rarer and easier to identify. Moreover, the more widespread the euphoria, the less worry there will be that tighter policy might inflict collateral damage on unaffected sectors. (BIS 2007-05-29:145-150).”

Some useful terms

Arbitrage < Trade and Freight: “The purchase of physicals or futures in one market against the sale of physicals or futures in another market in order to exploit price differentials between these markets. In moving physical oil between markets, the price differential has to be large enough to cover freight, insurance, volumetric loss and other handling charges. When this condition is met, the ‘arbitrage window’ is said to be open.” (OMR 2008-0

Supply ‘Push’ < Trade and Freight: When trade is motivated by output surpluses at the point of origin often signalled by weakness in local refining margins and/or by weak relative prices.

Bearish and Bullish < Prices: Factors which are likely to depress prices are defined as bearish while factors which are likely to raise prices are defined as bullish.

Derivative contracts
based on different types of assets such as oil commodities, equities (including private equities), interest rates, etc reduce the risk for one party by increasing it for another. By entering into contracts based on imagined or virtual futures, contracts attempt to manage risk by mitigating uncertainties based on the availability of the commodity (supply) or on price uncertainties (demand).

Futures Contract < Prices: A regulated, legally binding agreement made on the trading floor of a futures exchange to buy or sell a fixed quantity of a commodity for delivery at a specified time and location in the future.

Futures Transaction < Prices: Purchase or sale of a futures contract; exchange of a futures position for the physical or cash commodity.

Hedge < Prices: A financial transaction to mitigate risk. For example, taking an equal and opposite position on the futures market to that held in physicals to reduce price exposure in physicals (see Short Position, Long Position, Basis Risk).

Long Hedge < Prices: The purchase of futures or other paper contracts, against the sale of physicals (to reduce exposure to a price rise). Also called a Buying hedge. (See Short Hedge.)

Long Position < Prices: The net exposure of a trader (or group of traders) when their bought (long) physical or paper exposure exceeds their sold (short) positions (see Short Position).

NYMEX – Prices: New York Mercantile Exchange, the commodities futures exchange.

Short Hedge < Prices: The sale of futures against the purchase of physicals (to reduce exposure when a price decline or bearish trend is perceived) (see Long Hedge).

Short Position < Prices: The net exposure of a trader (or group of traders) when their sold (short) physical or paper exposure exceeds their bought (long) positions (see Long Position).

Spot < Prices: A one-time open market transaction where physical oil or products are traded at current market rates. The term is also often used to refer to a front-month futures contract.

A Selected Timeline of Related Critical Events

1930-05-17 The Bank for International Settlements (BIS) was established as an international bank for central banks which promotes international monetary and financial cooperation and strongly advises caution against fraudulent schemes. It is still functional and valued as a source of research accuracy in 2008.

1930s The Bank for International Settlements (BIS) acknowledged that economics is not a science as revealed in such glaring knowledge gaps as this lack of predictions of the Great Depression of the 1930s (BIS 2007-05-29:139).

1970 “The Great Inflation in the 1970s took most commentators and policymakers completely by surprise, as did the pace of disinflation and the subsequent economic recovery after the problem was effectively confronted (BIS 2007-05-29:139).”

1990s Economists were unable to predict the crises which affected Japan and Southeast Asia in the early and late 1990s (BIS 2007-05-29:139).

1995 Due to a naive, under-regulated and poorly managed financial environment, Nick Leeson, a trader at an old respected financial institution, Barings Bank incurred a $1.3 B. loss for the bank causing its bankruptcy by making large, unauthorized investments in index futures trading.

1998 In terms of microeconomics, economists were unable to predict the failure of LTCM in 1998, “the firm faced price shocks in various markets that were almost 10 times larger than might reasonably have been expected based on previous history. As a result, its fundamental assumptions – that it was adequately diversified, had ample liquidity and was well capitalised – all proved disastrously wrong” (BIS 2007-05-29:139).

2005-Q4 The combined turnover in the world’s derivatives exchanges for exchange-traded derivatives (ETD) and over-the-counter (OTC) derivatives was $344 USD trillion (Bank for International Settlements).

2006 Buoyant economic growth from January through June 2006 led to concerns that the global economy might be approaching a “speed limit”. “Oil prices increased by more than 35% in dollar terms between February and August on the back of persistently strong demand growth. Moreover, signs that slack was evaporating in major economies gave rise to concerns about overheating. Long-term inflation expectations in financial markets rose temporarily in the first half of 2006, especially in the United States (see Chapter IV), and financial market volatility increased sharply, if briefly, in May (see Chapter VI).” (BIS 2007-05-29:12).

2007-06 The total outstanding notional amount of over-the-counter (OTC) derivatives market was $516 trillion USD (Bank for International Settlements).

2007-05 The Bank for International Settlement report revealed concerns that short-term inflation could lead to long-term inflation due to high crude oil commodity prices in the spring of 2007 (BIS 2007-05-29:59).”

2008-01 through 2008-06 The price of oil on the futures markets climbed 40% between January and June 2008 (Lewis 2008-06-09).

2008-06 “Oil’s six-year rally has gathered pace this year, with futures markets climbing by roughly 40 percent since January (Lewis 2008-06-09).”

2008-06-06 The dollar plunged on Friday after U.S. economic data showed the biggest jump in the U.S. unemployment rate for 22 years, denting expectations the Federal Reserve would raise interest rates. It has been suggested that The weakness of the U.S. currency has been a major factor behind price gains across the commodities complex as dollar-denominated raw materials are relatively cheap for non-dollar buyers and offer investors a potential hedge against inflation. (Lewis 2008-06-09).

2008-06-09 “Oil fell on Monday, but held close to record levels after the biggest one-day price gain in the history of the market left traders and analysts divided over the explanation (Lewis 2008-06-09).”

Who’s Who

The Bank for International Settlements (BIS) “is an international organisation which fosters international monetary and financial cooperation and serves as a bank for central banks. The BIS fulfils this mandate by acting as a forum to promote discussion and policy analysis among central banks and within the international financial community, a centre for economic and monetary research, a prime counterparty for central banks in their financial transactions and an agent or trustee in connection with international financial operations. The head office is in Basel, Switzerland and there are two representative offices: in the Hong Kong Special Administrative Region of the People’s Republic of China and in Mexico City. Established on 17 May 1930, the BIS is the world’s oldest international financial organisation. As its customers are central banks and international organisations, the BIS does not accept deposits from, or provide financial services to, private individuals or corporate entities. The BIS strongly advises caution against fraudulent schemes.” Bernanke, an MIT professor appointed by President Bush to head the Federal Reserve is also on the Board of Directors of the Bank for International Settlements.

Webliography and Bibliography

2008-05-29. “Double, double, oil and trouble.” The Economist print edition.

BIS. 2007-06-24. 77th Annual Report. Basel, Switzerland. 244 pp.

International Energy Agency (IEA). 2008-05-13. “Oil Market Report (OMR).” PARIS, France.

Krauss, Clifford. 2008-o6-09. “Rural U.S. Takes Worst Hit as Gas Tops $4 Average.” Business. New York Times.

Lawler, Alex. 2008-06-10. “Oil’s record jump defies single explanation.” Reuters UK.

Lewis, Barbara. 2008-06-09. “Oil falls after record $11 surge.” Reuters. Boston Globe.

Ticker. 2008-06-10. “Rosengren: Dollar’s impact on oil is modest.” Boston Globe.


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