Thursday, May 29, 2008

Is It An Oil Bubble? Soros vs. Krugman

So who's the better prognosticator?

The investor whose fund made US2.9 billion last year with returns of over 30%?
George Soros, a legendary hedge fund investor, blamed the spike in oil prices – which peaked at $135 a barrel for the first time last week – on investors betting that the cost of oil will continue to rise, in an interview with the Daily Telegraph.

He said that the bubble will correct, but warned that this will not happen until the US and UK fall into a recession.

Or the economist/professor/columnist?
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.

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. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.
Frugal Ben Says: We will revisit this post in 12-18 months to see if practical experience trumps a priore reasoning from a model.

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