Tuesday, May 13, 2008

Possible Causes of Rise in Oil Prices

The Hindu editorialized a couple of days ago that the rise in oil prices was largely owing to speculation.

...today’s markets are being driven entirely by short-term factors. And the two most important ones are speculation and the declining value of the dollar. As the greenback loses value in relation to other currencies, the price of all dollar-denominated commodities will rise as suppliers seek to maintain their purchasing power. Speculation may be a rather more complex phenomenon but one thing is certain. The greater the uncertainty, the greater the likelihood of speculative activity on the oil market.

As a reader Vinay Kumar pointed out in the paper today, there are reasons to doubt that.

The editorial “Behind the oil price spike” (May 12) says the rise in oil prices is mainly due to the declining value of the dollar and speculation. While the dollar has fallen against the euro in the past one year, it has been quite resilient against most other global currencies. Further, historically, there has been no strong correlation between the strength of the dollar and the price of oil. The role of speculators may also be exaggerated. As Paul Krugman points out in his latest article “The oil nonbubble,” the telltale signs of speculators in action are not there in today’s oil market.

Paul Krugman indicated in his weekly column why speculators appear not to have had much of role in this phenomenon.

The only way speculation can have a persistent effect on oil prices...is if it leads to physical hoarding — an increase in private inventories of black gunk...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.
Becker takes a middle view that factors in not only speculation but also supply problems in other countries.

The present boom in oil prices has been mainly driven by increases in demand from the rapidly growing developing nations, especially China, India, and Brazil, although output growth in the US and European have added to world demand, and speculation on potential future price increases also contributed to the increased price of oil. To be sure, supply problems in Nigeria, Venezuela, Russia, and other major oil-producing states have contributed to accelerations in the oil price increases at times during the current boom.
Not sure who is right but in the meantime, there has been a disturbing prediction by Goldman Sachs today that not too long from now, oil prices may reach $200/barrel. Sounds like hard days are ahead.

4 comments:

sinnaraja said...

Krugman is just giving a leftwing version of "let's blame India and China" for the oil price hike. The fact is that annual increase in demand globally is just 1.5 per cent and this is simply not enough to explain price hike. Speculation includes a lot of factors, but is essentially driven by uncertainty -- especially about future supply because of declining production, harder extraction, fears of war, etc.

Pilid said...

Sinnaraja,

There is also Krugman's counterpoint that stockpiling - a symptom of speculation - has not taken place. I believe Becker's analysis that short-term supply problems are responsible for the recent spike is a reasonable one.

Anonymous said...

No short-term supply issues can explain price rise of 150 % in 4 years. Month-to-month supply-demand balances show no major deviation. When you have forward trading, you have speculation without accumulation of stocks. Prices go up without physical supplies moving here and there.

Pilid said...

Anon,
Thanks for that point. You may well be right. The sustained rise in prices over 4 years has been attributed to increased energy demand from India and China. Not sure why neither Krugman nor Becker mentioned forward trading and why Krugman thinks that continued rise requires stockpiling. Thanks for the comment which is a very worthwhile thought.