Bubble Talk

Recently, there has been a great deal of talk regarding oil prices and the possibility of a bubble. Predictions of $200 oil are now becoming more common. Folks like Paul Krugman don’t believe that prices are out of line with fundamentals. However, given the fact that oil prices have risen over 100% in the past 52 weeks, this must mean that something is wrong. Either we had the price wrong last year or the price is wrong this year. Arnold Kling therefore poses the following question:

Early in 2007, the price of oil was $60 a barrel. Recently, it has been above $130 a barrel. Which of the following does Paul Krugman believe:

(a) market fundamentals justified $60 a barrel then, and they justify $130 a barrel now; or

(b) market fundamentals justified a much higher price in 2007?

I believe that (b) is more likely to be true, meaning that we had what Tyler Cowen calls an “anti-bubble” in oil.

We know that Krugman does not believe that today’s oil price is out of line with fundamentals. Krugman’s view, in effect, is that if speculators artificially boost the price of oil, then supply will exceed demand, and the excess has to go somewhere. Where are the inventories?

This view ought to hold in reverse. If speculators artificially kept the price of oil too low early in 2007, then demand should have exceeded supply and inventories should have vanished. Yet they did not. So is Krugman forced by his model to conclude that the price of oil of $60 also reflected fundamentals?

Meanwhile, James Hamilton answers:

Where are the inventories? China already burned them.

So where do I come down on this question? I believe that we are in the midst of an oil price bubble. Let’s look at some of the facts:

1. As I have previously stated, the fact that oil prices are rising must faster than the real rate of interest (which may, in fact, be below zero) is causing oil companies to leave the black stuff in the ground.

2. Changes in daily futures prices for oil exhibit positive long-run persistence, which can suggest behavior consistent with herding.

3. The Federal Reserve is incredibly accommodative at the moment.

In my mind, there are too many factors that are pushing the price up that are beyond what the fundamentals would dictate.

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