Speculation and Bubbles

Suppose you think that a hurricane might disrupt oil flows in the future. What should you do today? Tropical storm Edouardo gives an example. As the storm approached, people believed there was a chance that oil flows would be disrupted in the future, and the current price began rising as a consequence. If you expect a higher price in the future due to reduced supply or any other reason, you should begin purchasing and storing oil now to take advantage of the higher price in the future, and the increased demand for oil drives today’s price up.

This is speculation, the storm may or may not actually hit and disrupt oil supplies, but it’s not the kind of speculation we should worry about. We want this kind of speculation – which reflects underlying fundamentals – to occur. The expectation of a supply disruption in the future causes the market to take actions today and store oil for when it will be needed, and this provides insurance against the potential supply disruption, insurance that reflects the probability that the storm will cause problems (the larger the expected fall in future supply, the bigger the price change, and the more that will be stored for the future).

In this particular case, the insurance wasn’t needed, but it’s still good to have:

”It is pretty much expected the storm is going to slowly weaken now for the rest of the day and overnight,” said Mike Pigott … of … AccuWeather… ”It wasn’t anything unusual or spectacular; there wasn’t any kind of massive intensification that we saw with Dolly.” …

Crude oil touched a three-month low of $118 a barrel on speculation Edouard wouldn’t curtail production. Six rigs and 23 platforms were evacuated in advance of the storm, the U.S. Interior Department said yesterday.

Royal Dutch Shell Plc, Europe’s largest oil company by market value, said the storm was no longer a threat and it would start regularly scheduled crew changes for its off-shore facilities, according to spokeswoman Darci Sinclair.

Noble Corp., the third-largest U.S. offshore oil driller, may have crews back on two submersible rigs by tomorrow.

The kind of speculation we should worry about is "bandwagon behavior." This is speculation that is disconnected from fundamentals. For example, suppose that people become convinced that offshore drilling will have a large impact on future prices. Even though this isn’t true, suppose people become convinced that it is true through some sort of misleading information campaign, perhaps abetted by a media more interested in hyping controversy than in informing people of the facts.

This is the opposite of an expected supply disruption, it’s an expected increase in future supply (based upon false information), so the expected future price would be lower. That would cause speculators to release stored oil – it’s not as valuable in the future as it was before – driving the price down today, and this validates the markets anticipation that price would fall. Even if you know that the underlying basis for the fall in price is false, if you expect the price to fall further you may jump on the bandwagon and sell stored oil now before the price actually does falls further, and this will amplify the fall in price. To the extent that the fall in price then becomes self-validating, people afraid of a fall in price sell oil which causes the price to fall generating more sales and further price declines, the behavior can feed on itself and generate a large downward fall in prices.

None of this is based upon underlying fundamentals, it’s all generated by people buying into the idea that drilling will have a substantial impact on future prices, and changing their behavior because of it. As a political strategy, I suppose it can work if you don’t mind misleading people and sacrificing the environment for political gain – prices fall and you can point to the change as evidence that your policy has helped consumers at the gas pump. But eventually the (negative) bubble will pop (hopefully after you are elected), and prices will return where they started.

This type of speculative behavior – bets on price changes that are driven by something other than the underlying fundamentals – is harmful since it distorts both the intertemporal allocation of resources, and the allocation of resources at a point in time. I’m not saying that selling the false claim that drilling for oil will have a large downward impact on prices will create the kind of bubble that makes a bang heard round the world when it pops, or even necessarily affect prices noticeably now or in the future. I think most of the price changes we’ve seen can be explained by changes in the underlying fundamentals (e.g. see above for an explanation for part of the recent price drop). But the attempt at a distortion is noteworthy in and of itself because if the attempt is successful, it can cause waste and inefficiencies. It shows political gain is more important than telling the truth and solving the problem. Because the fall in price is not based upon fundamentals, it’s still a bubble, or perhaps more accurately in this case if I’m wrong and there has been an impact, it’s froth (since the price changes we’ve seen are relatively small compared to the base), and this sends false signals about where resources are needed the most. The people who are doing their best to reinforce the misperception that drilling will significantly impact prices are, to the extent that they are successful, imposing costs on the economy for political gain. This is not the type of speculation we want to see.

This makes another important point. Bubbles do not have to be price increases, they can also occur when price falls (think of a fall in the stock market that is based upon rumors that generate a self-feeding downward cycle that eventually ends, and the price goes back to its fundamental value). We often think of large price falls as the price returning to its fundamental value, and many people are making that claim about oil prices presently, but if there is a negative bubble at work, the fall in price can be taking you away from, not towards, the long-run stable price.

Finally, prices can also be distorted by false information about fundamentals, i.e. an information campaign that misinforms about the relative merits of alternative proposals for dealing with the energy issue. For example, a distortion on the merits of conservation versus drilling could cause us to misallocate resources. Tire gauges and regular tune-ups can do more to help with the energy problem than drilling, but Republicans are doing their best to distort that message and push resources into a suboptimal use:

The Tire-Gauge Solution: No Joke, by Michael Grunwald, Time: How out of touch is Barack Obama? He’s so out of touch that he suggested that if all Americans inflated their tires properly and took their cars for regular tune-ups, they could save as much oil as new offshore drilling would produce. Gleeful Republicans have made this their daily talking point; Rush Limbaugh is having a field day; and the Republican National Committee is sending tire gauges labeled "Barack Obama’s Energy Plan" to Washington reporters. 

But who’s really out of touch? The Bush Administration estimates that expanded offshore drilling could increase oil production by 200,000 bbl. per day by 2030. We use about 20 million bbl. per day, so that would meet about 1% of our demand two decades from now. Meanwhile, efficiency experts say that keeping tires inflated can improve gas mileage 3%, and regular maintenance can add another 4%. Many drivers already follow their advice, but if everyone did, we could immediately reduce demand several percentage points. In other words: Obama is right.

In fact, Obama’s actual energy plan is much more than a tire gauge. But that’s not what’s so pernicious about the tire-gauge attacks. … The real problem with the attacks on his tire-gauge plan is that efforts to improve conservation and efficiency happen to be the best approaches to dealing with the energy crisis — the cheapest, cleanest, quickest and easiest ways to ease our addiction to oil, reduce our pain at the pump and address global warming. It’s a pretty simple concept: if our use of fossil fuels is increasing our reliance on Middle Eastern dictators while destroying the planet, maybe we ought to use less.

The RNC is trying to make the tire gauge a symbol of unseriousness, as if only the fatuous believed we could reduce our dependence on foreign oil without doing the bidding of Big Oil. But the tire gauge is really a symbol of a very serious piece of good news: we can use significantly less energy without significantly changing our lifestyle. The energy guru Amory Lovins has shown that investment in "nega-watts" — reduced electricity use through efficiency improvements — is much more cost-effective than investment in new megawatts, and the same is clearly true of nega-barrels. …

Of course, in recent years, the Republican Party has been affiliated with the oil industry. … John McCain has been a notable exception. He is not an oilman; he has pushed to regulate carbon emissions; and he opposed Bush’s pork-stuffed energy bill, which Obama supported. He also opposed efforts to drill in the Arctic National Wildlife Refuge and until recently opposed new offshore drilling. But now that gas prices have spiked, McCain is running for President on a drill-first platform, and polls suggest that most Americans agree with him. It’s sad to see his campaign adopting the politics of the tire gauge, promoting the fallacy that Americans are powerless to address their own energy problems. Because the truth is: Yes, we can. We already are.

Update: hilzoy has more on how Obama’s statement is being distorted for political gain (the claim McCain is making that he said putting air into tires is "enough to break our dependence on Middle Eastern oil" is false, Obama didn’t say that). Too bad we can’t count on the media to point out how McCain is misrepresenting both what Obama actually said and the facts about the impact of drilling on gas prices. pgl comments here with "Hot Air Lowers Gasoline prices!!!"

Update: "It’s like these guys take pride in being ignorant":

That’s a pretty good response to McCain making fun of proposals that could help families struggling to pay higher energy bills save money and gas. I guess it’s easy to poke fun at this when you have enough money not to have to care about saving a few dollars wherever you can, but shouldn’t he show more sensitivity to people who do have to care?

Update: Wow. Paris Hilton responds to the McCain ad: