Following on last week’s topic, some have suggested that maybe, like the housing bubble in the US, the spike in oil prices and their subsequent collapse could have been an oil price bubble that also pulled up the prices of natural gas.
First, we should examine the phenomena that govern the life cycle of the economic bubble-its start, growth and eventual collapse. There is no consensus on what causes a bubble. Further, one view is that a bubble can only be identified after it has manifested itself in all of its stages. It is not clear-cut since even now after the collapse of oil prices there are still questions as to whether there was an oil economic bubble. (Did we have a housing bubble?).
One thesis is that high market liquidity is necessary, though not a sufficient condition for its start. This encourages people to invest in a particular asset both to preserve the value of their money in the face of inflation, but also to sometimes sell at a higher rate later to make, as it were, a killing.
What was of particular concern in the US housing bubble is that people were persuaded to enter into mortgages that they could not really afford while the prices of the assets were rising. High liquidity encourages mark-up inflation across the board and investing in a bubble suggests that such activities may also be seen as hedges against headline inflation.
At the peak of the bubble the price fetched by the asset is far greater than the real market value, even to produce it from scratch. When the bubble bursts, prices fall and many are left with an asset, say, houses, for which they hold inverted mortgages whose values are far in excess of what the asset is worth.
Also, the mortgagee may not be able to service these assets and we have heard stories of people returning the keys of houses to the banks and walking away in the aftermath of a bubble. Looking back at the investment frenzy of the bubble many commentators have remarked on the herd instinct of the investors -more like a stampede as the herd races towards a cliff.
Last week’s article demonstrated that because of the absolute elasticity of the supply of paper-oil on the futures market, this market on its own, without reference to the economic fundamentals of the physical-oil market, cannot support a bubble. Therefore, the evidence, if any exists, has to be sought in the physical market.
In order for speculators to influence the trend price of physical-oil, futures and index investors have to continue to buy large quantities of physical-oil and hold these quantities off-market. There is no evidence that this occurred and if it did it would have to be immense quantities to manipulate a worldwide physical market as large as the present crude oil market.
Yet because of Peak Oil a bubble in oil prices could be established. Oil inventories were not excessive and any increase that there was can be explained away by the fact that oil use, particularly in China and India, also increased, impacting positively on the associated inventories.
Another test for an oil bubble (Stuart Sandiford in the Oil Drum, ’Is Oil in a Price Bubble’) is the rate at which the asset price increased and if this was faster than exponential growth a bubble is in the making.
When the US housing bubble was tested it was seen that at least in 21 states the price exceeded exponential growth. This test was applied to oil prices, e.g. between January 2000 and 2007 West Texas Intermediate oil prices were volatile but the trend in prices did not exceed exponential growth. Sandiford concludes the oil prices were not in a self-reinforcing bubble.
But what of today? The price of oil is on its way back up from its low in the US$30 range and is now at US$80/bbl and natural gas at Henry Hub is US$4.8/mmBtu. China has spent US$15 billion in gas and oil for the year (double that of last year), in an attempt to stock pile against price volatility.
If one were to examine the depreciation of the US dollar (the currency in which oil/gas prices are quoted) then with the US dollar now pegged at 1.09 Euros, the lowest it has been for seven months, it is clear that oil price adjustment is in part related to producers trying to counteract the depreciating US dollar and (temporary) stockpiling.
As the US dollar depreciates the TT dollar (tied to it) also depreciates, compounding its local depreciation against the US dollar. Thus our foreign revenues will reflect this US dollar depreciation, stockpiling and the resulting price volatility.
