Update on why crude oil prices spiked last year

This recent blog post by Professor James Hamilton at UCSD tries to tie last year's crude oil price spike to fundamental market forces.  I commented that in high price ranges large sovereign suppliers have a reversed supply curve--they want prices lower because they don't want customers to shift away from petroleum and they only need enough income to balance their budgets.  I also linked to Mark Thoma's persuasive argument that crude oil prices were being bid up in substantial part as part of a broader waive of coordinated commodity price increases (even though the likelihood of coordinated changes in fundamentals across all commodities is miniscule). 

Then Get Rid of the Fed commented with a link to an undated paper by Paul Krugman several years ago in which he showed a reversed or serpentine supply curve for petroleum and suggested there could be multiple equilibrium prices. When Krugman addressed crude oil prices in a series of blog posts in the spring of 2008, I don't think he referred to this.  As I recall, he started with rather conventional crossing SS and DD curves and ended with a vertical SS curve, all the while talking about whether there was hoarding that could distort fundamentals.  He never warmed to the idea that speculators in the options market could be affecting current OPEC prices.  He should.

Update on Monday, April 6, 2009 at 09:49AM by Skeptic

Light crude oil futures on NYMEX had traded in the range of $50 to $78 from March 2005 to August 2007, when they had retreated a bit to $70. At that time the Goldman Sachs index of combined commodities futures was about 480. Charts are here. After that they rose together until July 2008 and then both declined in concert. Crude oil futures rose 110% from $70 to $147 and then declined 73% to $40 in December 2008, while the Goldman index rose 81% from 480 to 870 and then declined 63% to 320. Crude oil was somewhat more volatile than the Goldman index, but both made big moves in the same directions at the same times. In conclusion, it seems to me that everything above about $70 per barrel was speculative bubble.

Update on Friday, September 25, 2009 at 08:17PM by Skeptic

Speculators, who held 20% of oil futures in 2002, now hold 50%, and movements in oil prices have become more correlated with dollar exchange rates, according to this recent paper.

A new policy paper by Rice University's Baker Institute for Public Policy shows a clear increase in the size and influence of noncommercial traders, or "speculators," in the oil futures market since regulations were eased by the Commodities Futures Modernization Act of 2000. Speculators now constitute about 50 percent of those holding outstanding positions in the U.S. oil futures market, compared with only about 20 percent prior to 2002.

The report also finds that the correlation between oil and the dollar has strengthened significantly over the past several years. The coauthors of "Who is in the Oil Futures Market and How Has It Changed?"-- Kenneth Medlock and Amy Myers Jaffe -- advocate that the government should revise its policies to reverse these trends. Kenneth Medlock is an energy fellow at the Baker Institute and adjunct professor of economics. Amy Myers Jaffe is a fellow in energy studies at the Baker Institute and associate director of the Rice Energy Program.

Update on Thursday, December 10, 2009 at 12:06PM by Skeptic

Professor Hamilton has evolved.  In this post, he cites recent work of others that persuades him that commodities speculation was a major cause of the crude oil price spike in 2008.  He presents charts showing that price movements of oil and several other commodities, which had been essentially uncorrelated for 20 years, started in 2005 to become quite correlated.  Since fundamentals of supply and demand for cotton, live cattle, soybean oil, copper, etc. do not change in synch with the fundamentals for crude oil, the most reasonable explanation for the increasing correlation is that investors were buying all commodities as another asset class. 

Professor Hamilton goes on to warn that this trend of heavy "investment" in commodities continues and that it could drive inflation in the real economy even though labor costs and demand are stagnant.  I wonder if the oil price spikes of the 1970s were a major contributor to the stagflation we had then. Commodities speculation is one way in which the financial economy affects the real economy--and not in a good way.  Even more destructive than the impact on energy prices is how the spike in commodities prices greatly increased food insecurity in much of the world. The renewed threat of food insecurity has caused many nations to reconsider whether trade liberalization and globalization are good for them. Commodities speculation on a modest scale can dampen volatility, but at the higher volumes we're seeing now, speculation can greatly increase volatility, which is bad for everybody that is not playing in that market.