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As oil prices have begun to rise in 2009, the question is whether the world is in for another oil price spike similar to the one in early 2008 that could choke off the nascent recovery of the world economy. To judge whether such an outcome is in the cards, one has to look closer at developments in the oil market in 2008 when oil prices shot up from $90 a barrel in January to a record high $147 a barrel on July 11. Several hypotheses have been advanced to explain the climb in oil prices—peak oil, market fundamentals, and speculation. Examining these theories can help answer the question of whether the oil price increase of over 50 percent in the first six months of 2008 was a bubble. And if so, was the subsequent collapse to $40 a barrel by December the bursting of the bubble?
Consider first the peak oil theory, which basically says the world is running out of oil. Circumstances in the global oil market do not support this theory; it relates mainly to the long run and certainly cannot explain the run up in oil prices over a few months and the sudden fall in the second half of the year.
Market fundamentals of demand and supply are certainly important, but they are not the whole story. Even though world real GDP growth in the first half of 2008 was about the same as it was in 2007, the demand for oil actually fell while supply rose. According to market fundamentals, prices should have fallen, not risen spectacularly from January to June.
The third hypothesis, speculation on the future price of oil, has considerable support. The volume of oil futures has grown enormously in the last few years, with the average daily trading volume in 2008 about 15 times the daily world production for oil.
If one knew the equilibrium price of oil, determined by fundamentals, then one could figure out the effect of speculation. One possible indicator is the market valuation of major oil companies, which reflects long-term oil price expectations. Short-term deviations between valuations and spot prices are then temporary. The data support this hypothesis. The equilibrium price was about $80 to $90 a barrel in 2008, while spot prices averaged $120 a barrel in the first half of 2008. One could say this was a bubble, with the difference between the two prices a result of speculation.
What then does the 2008 phenomenon imply for the future? There will be upward pressure on oil prices as the world emerges from recession, demand for oil picks up, and inventories fall back to their average or normal levels. Whether this will turn into a 2008-type bubble depends on speculation in the oil market. If the policies being considered by the US Commodity Futures Trading Commission to put aggregate position limits on futures contracts are implemented, the likelihood of another bubble would be significantly reduced.
This posting draws from Mohsin Khan’s PIIE Policy Brief on the 2008 oil price bubble.