on being wrong…

Posted on Sunday 7 December 2008


Krugman: The so-called oil bubble
By Paul Krugman
Published: May 12, 2008

‘The Oil Bubble: Set to Burst?" That was the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse. Ten months later, oil was selling for $70 a barrel. "It’s a huge bubble," declared Steve Forbes, the publisher, who warned that the coming crash in oil prices would make the popping of the technology bubble "look like a picnic." All through oil’s five-year price surge, which has taken it from $25 a barrel to last week’s close above $125, there have been many voices declaring that it’s all a bubble, unsupported by the fundamentals of supply and demand. So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble?

Now, speculators do sometimes push commodity prices far above the level justified by fundamentals. But when that happens, there are telltale signs that just aren’t there in today’s oil market. Imagine what would happen if the oil market were humming along, with supply and demand balanced at a price of $25 a barrel, and a bunch of speculators came in and drove the price up to $100.
This is what would did happen to the price of gasoline:
Even if this were purely a financial play on the part of the speculators, it would have major consequences in the material world. Faced with higher prices, drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production. As a result, the initial balance between supply and demand would be broken, replaced with a situation in which supply exceeded demand. This excess supply would, in turn, drive prices back down again – unless someone were willing to buy up the excess and take it off the market. The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding – an increase in private inventories of black gunk.
Right now, a little over 3 months after the bubble burst [the one Krugman couldn’t yet see when he wrote this article], there are tankers filled with oil being stored [horded] all over the Gulf.
This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling. But it hasn’t happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices these past few years had to happen to keep demand growth from exceeding supply growth

Again, I wouldn’t be shocked if oil prices dip in the near future – although I also take seriously Goldman’s recent warning that the price could go to $200. But let’s drop all the talk about an oil bubble.
So the Oil bubble burst almost exactly one month after Krugman wrote this article. Paul Krugman is a Princeton Econ Professor, a New York Times Columnist, and this year’s winner of the Nobel Prize in Economics. But here he is explaining that the inflated oil prices are due to "fundamentals," not the result of speculation, unaware that the OIL bubble [that he cannot see coming] will burst shortly. What does it say that Krugman of all people, America’s Economist, was so very wrong about this?

I don’t know the answer to that question, but I’m pretty sure it doesn’t say something about Paul Krugman. I’m guessing it says something about this market. As the gasoline prices have soared, we’ve all felt that the OPEC people were doing it to us, or that the world’s oil reserves are finally drying up, or that the big oil companies with their record profits are profiteering. I expect that all of those things are true, but what we [and Paul Krugman] missed was that there was a financial bubble driving things – speculation on the oil market catching fire and feeding on itself.

All of this talk of "bubbles" may seem heady and speculative. I don’t think so. I think it means that our "free market economy" has, once again, proven that it is like dry trees in the California foothills – a wildfire waiting for a spark or a loose cigarette butt. Unregulated Capitalism is too dangerous. The opportunities for the market being driven by marketeers rather than the commodities themselves are too great. Market regulation isn’t just an option, it’s the option

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