Posted by Daniel Hall on December 30, 2008
There has been a bit of discussion in the comments to my previous oil post about the role speculation played in both the rapid rise and spectacular collapse in oil prices over the last 12 months. Commenter Dave Sawyer sums up the idea:
What about good old speculation? Seems that with the demand growth and price rise, hot money flowed in and further drove up prices. With the credit collapse, and all the associated margin calls, the same then became true in reverse. A demand destruction and speculation downward spiral.
I am reflexively skeptical about arguments that use speculation to explain a large portion of price movements. Liquidity can probably help push up prices a bit but positing large price increases from ‘hot money’ seems to be an argument that extra liquidity is will primarily encourage investors who are long oil but that same liquidity will do little to encourage other investors to take the opposite bet. I like these thoughts from Geoff Styles when he sums up the “Energy Lessons of 2008“:
- Demand matters as much as supply in determining prices. The difference between oil at $145 per barrel and $40 is only a couple of percent of global demand, or more precisely a swing between steady growth of 1-2% per year and a shrinkage of similar magnitude.
- Speculation can amplify prices and market volatility, but it can’t override a dramatic shift in the underlying fundamentals of supply or demand. Leverage increases not only the magnitude of speculative gains and losses, but apparently also the speed of the shift from one state to the other.
Think about that final sentence!
The one additional point I would make is that even if speculation can push up prices a bit in the oil market, the oil that is consumed is actually worth the money that is paid for it. Even when oil was $145 a barrel, every barrel that was consumed — all 85 million a day of them — was worth at least $145 to the person that was buying it. That doesn’t mean that oil is worth that much in the long-run — I suspect we are going to see a long-term demand shift in the West that will be comparable to the demand shift that followed the 1970s oil crisis — but in the short-run oil is very, very valuable to those who need it.