Why the Oil Price Rise Is (Probably) Not a Bubble

I’ve suspected for a while that we were in a speculative bubble with respect to oil prices.  Paul Krugman offers a good insight into the question.  (When he’s not preoccupied with left-wing rants, he’s a pretty good economist.)  He says (full article here):

… there are only two things you can do with the world’s oil production: consume it, or store it.

If the price is above the level at which the demand from end-users is
equal to production, there’s an excess supply — and that supply has to
be going into inventories. End of story. If oil isn’t building up in
inventories, there can’t be a bubble in the spot price.

So I looked into oil inventories:

We don’t seem to have much increase in inventories.  Maybe it’s building up outside of OECD countries, where we don’t have good data, but if I were going to store millions of dollars of oil in some tank farm, I’d want it in a stable country with secure property rights.  So the oil is probably not hidden in Somalia or Zimbabwe.

What about futures markets?  Let’s say that we are in equilibrium (current supply equals current demand) and then speculators bid up the price of oil in futures markets.  If today’s spot price does not rise, then I can buy a barrel of oil today, store it for a few months, and deliver it to fulfill my futures contract.  This arbitrage will bid up today’s price.  But if today’s  price is bid up by speculators in the futures market, we end up with more supply and less demand–which means inventories have to build up.

Think about past bubbles.  In the housing bubble, the inventory of vacant houses, condos and apartments rose (as I’ve noted frequently in this blog).  In the tech bubble, the inventory of shares of stock mushroomed.  In the tulip bubble, people hoarded tulips for investment purposes (I think).

Tyler Cowen over at Marginal Revolution notes that inventories could be building up underground, as producers choose to not maximize their current pumping.  Seems unlikely, though possible, to me.

So the high prices are most likely due to strong demand and long time lags in exploration and development.