Boiling in oil

I think you've got to have your head in the sand not to recognize that there is some new speculation in the commodities markets. However, the difficulty is in estimating the impact of this speculation, and in trying to figure out what the price of oil would be in lieu of it. I've already said that $75 would be a reasonable estimate, but that's not founded on the firmest of thinking; it's really just a guess based on where the price was at before so much money started pouring in. But let's assume that's correct, and move on to discussing whether that means that at oil at $137 is currently in a bubble. Well, yes and no, seems to be the answer. Yes, in the sense that if this speculative money chose to speculate elsewhere the price would be instantly cut in half. But no, in the sense that it's difficult to see the real price of oil being any lower 20 years from now. There's lots of demand, there's little new supply, and ultimately, there's a fixed amount of this stuff.

This presents the same type of puzzle that you find with the equity premium. You know that stocks consistently outperform bonds over long times periods (a 98% certain conclusion at the 20 year horizon, if I remember correctly). You have 200 years worth of data to this effect -- essentially the entire history of modern capitalism confirms this fact. So, then, knowing this, why doesn't a rational long-term investor bid stocks up to a level now which implies that they will only generate the same return as a bond in the future? This in fact, was the argument behind all those Dow X00,000 books during the internet bubble. Of course, there are good reasons why this doesn't happen, and why it was perfectly fair to call the Nasdaq a bubble back in 2000 -- not everybody invests for 20 years, the appropriate valuation level depends on things that are tough to predict like productivity growth, etc -- but one of the most important reasons this doesn't happen is pointed out here:

Burton Malkiel, a Princeton University economics professor and author of ``A Random Walk Down Wall Street,'' says the rise in oil may be justified because supplies are limited and demand in developing economies is increasing. That distinguishes oil from the market for technology stocks in the 1990s, where supply ``could be expanded infinitely'' and new stock issues helped push down prices, he said.

``The picture is fundamentally different than the Internet picture,'' Malkiel said in an interview from Princeton, New Jersey. ``I'm not saying we're running out of oil, but we're clearly supply-constrained. Five and 10 years from now, the price is going to be higher than $134.''

The idea of Dow X00,000 is a self-defeating prophecy because everybody takes advantage of it to create more supply of stock.

On the other hand, with oil, you have a different wording here of the "peak oil" hypothesis; at some point the limited supply of this stuff starts to be a factor in the price. As an oil producer, if you know the price of oil is going to rise, it behooves you to just leave it in the ground, unless of course you could make more by pulling it out of the ground, selling it, and investing the money in bonds. In equilibrium, you have what is called Hotelling's Rule which predicts that the price of a finite commodity will rise at the rate of interest. So the price increase can't really be called a bubble, if you have a fundamentally rational economic theory that would predict it. The question is whether we've really reached peak oil and this anticipation of scarcity has started to be incorporated into the price. The fundamentals folks insist that the real price of oil is only just now regaining its 1980 highs, so in reality its just making up for lost time, as it were, by spiking now. I think this argument actually has some merit to it, and is a reason not to believe that oil will sink back to the marginal cost of production, but I'm skeptical that it completely justifies the current price level.