March 17, 2008

Riding Out the Oil Bubble

By Benjamin Artz

The United States economy has experienced two massive asset bubbles in recent memory.  The first was the dot-com bubble that fueled a seemingly endless economic expansion and filled people’s pockets with money.  The second was the housing boom that gave home-owners huge unrealized gains in property values, providing investors with a large amount of equity of which to borrow against.  Both of these bubbles felt great when we were in their midst, but hurt immensely when they popped and sent the economy into a tailspin.  We suffered a mild recession after the first one and are suffering at least a very weak economy after the second.  Believe it or not, we seem to be in the middle of another bubble; but unlike the prior two, this one hurts almost everyone and will aid the same number if it ever bursts.

You may have guessed that I am of course referring to oil.  The price for a barrel of oil recently topped $100 when only six years ago its price was a mere $25.  There are many good economic reasons for why the price has increased in the past decade, yet there is only one that can explain why it has gone this far.  We are in the middle of an asset bubble much like the dot-com stock price bubble and the housing valuation bubble the economy is still suffering from.

Asset bubbles can occur for many reasons, but the core basis behind any bubble is speculation.  For one reason or another, investors believe that oil prices will continue to go up, despite no evidence of supply shortages and the first decrease in demand in the United States in over a decade.  Investors may have good reason to believe this; developing countries’ demand for oil not only increases swiftly every year but is artificially high from government subsidies to keep prices low for the consumers in those countries.  Also, political turmoil in the oil-rich nations prevents private industry from extracting oil in those nations to boost its supply.  But in addition to this belief of rising oil prices, speculative investors also must believe in the existence of a “greater fool”; there is always someone who is willing to pay a higher price for an asset than the selling price.

Recent activity in the oil futures market, which dictates the price of oil, gives evidence of speculative investors bidding up the price of oil by simply buying the commodity’s futures contracts.  Many new investors have joined the oil futures market in recent months, most being institutional investment funds like pensions.  Rather than buying stocks and bonds in a failing market, these funds are turning to purchasing commodities such as oil.  Indeed, the price of precious metals has also boomed in the recent past.  Also, the value of the dollar has fallen in the past few years relative to many major foreign currencies, allowing foreign countries to purchase more oil cheaply as the price of the dollar plummets, further boosting the price of oil for Americans. 

What makes this bubble different is that it impacts our everyday lives.  Oil is the main ingredient of gasoline and is therefore most responsible for gasoline’s price recently hitting inflation-adjusted record highs.  The dot-com bubble hurt afterward when people lost money and jobs.  The housing bubble hurt afterward when people could not access credit so easily or cheaply and lost their houses as a result.  The oil bubble hurts now, which is why everyone, except for oil investors, would like to hear the bubble deflate.  This will happen only if the economy heats up and the dollar rebounds.  Then institutional investors will look to financial assets rather than commodities for growth and foreign countries will find oil and gasoline to be even more expensive as the dollar climbs in value.  The price of oil will then follow a precipitous decline until American consumers can once again enjoy paying only $2.00 per gallon rather than well over $3.00.