Monday, May 12, 2008

Oil Nonbubble

Paul Krugman dives straight in today with an accessible post about how oil prices cannot be a bubble because there's no inventory. I think his reasoning makes perfect sense -- if the current increase in prices were due purely to financial players operating through the futures market, the prooposed speculative mechanism would involve an increase in inventories, which we are simply not seeing anywhere, as commodity inventories are at multi-decade lows for almost everything. Note that the best candidate for 'speculator' here is, paradoxically, the big ETF's and futures programs of pension funds that are getting into this market as a long-term asset class investment, so the role of speculation here should be read without the usual whiff of moral stigma people give it.

One answer to this has already been proposed -- that there are inventories, but because they are not being counted correctly because of the growth of all kinds of wacky OTC derivatives and other deals that the commodities markets have never seen before. There is an interesting commentary to this effect by a veteran commodities trader here. Of course, it's very hard to validate this line of thinking, which amounts to a sort of dark matter of the inventory world, because by hypothesis, you can't count these inventories. While arousing suspicion though, that fact alone does not mean that the theory is incorrect; the paranoid also have enemies. A related idea would suggest that instead of piling up as inventories, the boom in prices has actually caused a reduction in supply to the market, as we can easily read about grain elevators not accepting more corn simply because they are now unable to hedge against the price volatility. The basic idea remains plausible -- that the unprecedented wave of purely financial money at work in commodities is having an effect on prices -- even if the mechanisms are hard to pin down.

But so then where does this leave us with respect to a price prediction? Is oil going to $200 a barrel like Goldman Sachs says? My own feeling is that there is somewhat of a bubble in commodity prices, even though, like all good bubbles, it got started for fundamental reasons, some of which are still valid over the medium-term. In other words, we are seeing exactly the combination of real and fictitious price increases that makes every bubble so psychologically difficult to identify. If this idea is correct, we could see a major pullback in prices on the basis of speculation drying up, coupled with an almost assured global demand slowdown over the next year or so. A few things complicate this picture. First, as I mentioned, speculation here is less the famous hot money (surely along for the ride though?) than these giant pension fund and endowment ships. That is, financially, the bubble may still be in the inflation phase. Second, the effect of a global slowdown may be offset by negative real interest rates, which naturally makes commodities more attractive as a store of value and an inflation hedge. Finally, commodity prices may not being going back to their 2000 levels. We really do have several billion new and highly inefficient new entrants to the global economy via the industrialization of China and India. Demography is denstiny. In addition, this is happening right at the moment when the externalities associated with commodities are (potentially) going to be internalized in the price.

In summary, while there are good reasons to suspect a correction in prices from current levels, though it may not happen as quickly or dramatically as some think. Commodities may be going through a period of overshoot before reaching a new higher stable price regime.

Unfortunately, as we all know, economics is not a science because ...

No comments: