Monday, June 09, 2008

Is it real or just bubble?

Many considers the recent oil price hike is driven by speculative motives, not a real phenomenon. You know, like what happened to the stock market, currency, housing, property and the '90s dotcom companies. This article (from The Economist) said it may not be the case.

Here's the argument:
[There is no] evidence that the growth of speculation in oil has caused the price to rise. Rising prices, after all, might have been stimulating the growing investment, rather than the other way around.
And that is because:
Investment can flood into the oil market without driving up prices because speculators are not buying any actual crude. Instead, they buy contracts for future delivery. When those contracts mature, they either settle them with a cash payment or sell them on to genuine consumers. Either way, no oil is hoarded or somehow kept off the market.
That makes it harder for a bubble to develop in oil than in the shares of internet firms, say, or in housing, where the supply of the asset is finite.
[t]here is, admittedly, a growing category of inherently bullish investment funds that seek to track commodity-price indices, in which oil is usually the biggest component.
... even index funds make unlikely suspects. For one thing, they too invest in futures, rather than in physical supplies of oil. So every month, they must trade contracts that are about to fall due for ones that will not mature for several months. That makes them big sellers of oil for prompt delivery.

What is more, their growth is not as impressive as it first appears. Paul Horsnell of Barclays Capital, an investment bank, puts the total value of index funds and other similar investments at $225 billion. That is less than half the market capitalisation of Exxon Mobil, he points out, and a tiny fraction of the $50 trillion-odd of transactions in the oil markets each year.
That means that:
... the oil price is still a function of supply and demand. For the past few years, the world's production capacity has grown only sluggishly. Meanwhile, demand, especially from the developing world, has been growing faster. So there is hardly any slack in the system. Only Saudi Arabia and the United Arab Emirates are thought to be able to increase their output from today's levels, and even then, there are doubts, since Saudi Arabia, in particular, is secretive about the state of its oil industry.

That leaves the oil market at the mercy of even small disruptions to supply. Prices tend to jump each time militants sabotage an oil pipeline in Nigeria, bad weather threatens production in the Gulf of Mexico, or political clouds gather over the Persian Gulf.

The problem is exacerbated by a growing mismatch between the type of oil being produced and the refineries that must process it. The most common benchmark prices, including the one used in this article, refer to “light” crude, the least viscous sort, which produces the most petrol and diesel when refined. “Heavy” oil, by contrast, yields more fuel oil, which is used mainly for heating.

All of the above can be summarized in two words: demand, and supply.


  1. is there any method to detect a bubble before it bursts?

    or maybe, how do economists explain bubbles?

  2. There are contending views on that (you should know this already by now,guys!): those that subscribe to the view that you can look at 'fundamentals' to see if prices are above its value, there are other international money and finance economists who think that you can't really tell whether it's a bubble until it bursts.

  3. Roby:
    "or maybe, how do economists explain bubbles?"

    One approach: As the effect cascading signals (or noise) when the true parameters are hard to observe -- and hence, the answer for the first question is probably no.

  4. arya: 'hard to observe' seems to imply that economists know what to look for. is this really the case? or is it the case of unknown unknown?

  5. Arya: what kinds of true parameter are you talking about? because, i think, data about stock market, interest rates, or firm performance are publicly available.

    is this a kind of hidden variable argument?

    so if there's no way to tell whether there is a bubble or not before it actually bursts, then can we take seriously the economist' or a.p's argument that it's not a bubble?

  6. Tirta and Roby:
    The subject in "hard to observe" are market players, not economists; the variables of interest are those determining the (present and future) profitability of a particular market.

    If every market player has perfect information about this at every period, then there will be no bubbles. Now, if you believe that all relevant information is out there, then fluctuations are reflections of rational behavior, not a result of bubble.

  7. Arya:

    the more information market players have, the more able they measure the true quality/fundamental of the object, and so the outcome is closer to the true value/price of the object.

    is that right?

  8. Roby:
    Yes. What's key, however, is not that the information is available, but that market players can (and do) make use of them to make their decisions.

    Bubbles happen when the cost to make use of that information (ie., the fundamentals) is too high for most that they prefer to look at price fluctuations (signals/noise) to guide their buying decisions. Prices no longer reflect the true value of a good for the consumer.

  9. arya: ok. then the information here is limited to the information on the fundamentals, right?

    there are other kinds of information such as the behavior of other market players. and you consider this type of information as noise.

    my question is:

    in economic analysis/models, do you include the information on the behavior of other market players?

    if yes, how?

    if no, why?

  10. Roby:
    Yes. That's what game theory is all about. Unfortunately, it's very difficult to solve the equilibrium for heterogenous agents. As far as I know, there are some fairly simple economic models on information cascades (which explains how bubbles could occur).

    However, I imagine that finding the optimal strategy (for market players) and the equilibrium outcome is probably like trying to solve a super-chess game with thousands of heterogeneous players.

  11. Anyway, it is still real and rational if we expect a bubble in the market. But, the issue here is the information quoted from this post saying that there's no evidence of speculation in oil market thus showing a real price. How are we gonna digest that? If there were actually speculative tradings, the price may go down corrected to the trend. Then, after 5 years we can see the bubble from the graph. In conclusion, we can't see a bubble when it's occurring or just after it occurred.

  12. here's an abstract proposing a social explanation behind bubbles:


    Price bubbles remain a puzzle for economic theory, particularly given their appearance in experimental markets with high efficiency and minimized uncertainty and noise. We propose that bubbles are caused by the institutionalization of social norms, when individuals observe and adopt the behavior of others. Explanations of bounded rationality or individual bias appear insufficient as we show experimentally that (1) participants' pricing skills are better ex-ante than ex-post and (2) that individual discrepancies between intrinsic values and market prices become increasingly serially correlated during trading. We also find no support for the Greater Fool explanation.