Crude oil prices in 2008: Was the spike a bubble?

Michael Giberson

In the physical world, spikes and bubbles are quite different things that don’t generally get mistaken for one another.  Curiously, in economic metaphor, the same phenomena can be called a spike and a bubble.  Argument among economists continues on the issue of whether the oil price spike in 2008 was or wasn’t a bubble.

A few weeks ago Paul Krugman dismissed the idea that the 2008 run up in oil prices was a bubble, and suggested that high oil prices “are largely caused by fundamentals.” In a May 2008 op-ed Krugman also argued against the bubble claim, claiming that if speculators were to  blame there would be tell-tale signs like the accumulation of excess inventories.

Amy Myers Jaffe responded at the Baker Energy Institute Forum blog:

The problem with Krugman’s logic is that he was in factual error. Oil inventories were indeed increasing as prices were going up, and by a large amount, especially if you add in what we in the industry call “oil at sea” which refers to a build up of the number of large tankers of oil floating offshore or slow steaming to markets that lack sufficient demand for that supply.

Right around the time that Krugman declared that there was no oil bubble, Energy Intelligence Group was reporting that oil inventories in the industrialized countries had risen by 1.2 million barrels per day in April 2008, which put them well above the five-year average. In a telling sign of how limited on-land oil-storage space was at the time, Iran had to commission ten very large crude oil carriers (VLCCs) to hold its unsold oil afloat off its coast, a practice not seen since 1989, when oil prices were collapsing.

The problem with Jaffe’s response is that it ignores long established oil industry patterns. High prices or low prices, the industry tends to build inventory in the first four months of the year and draw down those inventories during the next five or six months. (For example: U.S. Energy Information Administration on oil stocks: “World oil stocks follow a seasonal pattern in which they are typically drawn down rapidly in the middle of the winter and re-built rapidly in the spring…”)

Jaffe needs inventories to accumulate in excess of normal industry practices to sustain her argument.  Her claim that inventories in April 2008 were “well above the five-year average” is ambiguous; was April 2008 inventory above the five-year average for that time of year or just above the average level for every month of the previous five years?  It makes a difference because it is ordinary for April to have higher inventories than any other month, and only relevant to the case if April 2008 was extraordinarily high.

I don’t have the Energy Intelligence Group data at hand, and I don’t find other world inventory data readily available.  U.S. inventory data from the EIA shows the typical pattern of inventory accumulation in the spring and draw down over the summer.  Early 2008 does show slightly higher inventories (less than 2% higher) relative to the average inventory for the same week of the year over the prior five years.  On the other hand, early 2008 also showed slightly lower inventories (less than 2% lower) relative to the average inventory for the same week of the year over the prior 20 years.  The inventory build up in early 2008 doesn’t seem so far off typical industry practices to justify bubble claims.

Admittedly, crude oil inventory is the U.S. is only a part of a bigger picture. If you have better data to share, I’d be interested.

The Iran anecdote that Jaffe tossed into here story seems to be the result of temporary and idiosyncratic conditions, so probably not revealing on the larger issue.  On May 2, 2008, Bloomberg reported:

Iran, OPEC’s second-largest oil producer, more than doubled the amount stored in tankers idling in the Persian Gulf, sending ship prices higher as demand for some of its crude fell, people familiar with the situation said….

While oil rose to a record $119.93 a barrel on April 28, Iran has a glut of its sulfur-rich crude as refineries that can process the fuel shut down for maintenance. The discount on Iranian Heavy crude compared with Oman and Dubai petroleum has more than doubled since the start of the year, according to data compiled by Bloomberg.

“There’s not much demand for heavier crudes such as those from Iran,” said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp. in Tokyo. “It’s the peak of the refinery maintenance season in Asia, and Iran also sells oil to Europe and the Mediterranean, where some refineries are having turnarounds,” or seasonal shutdowns for repairs, he said.

I’m not claiming Krugman is right; I generally don’t read Krugman and particularly don’t rely on his opinions on energy market issues. I’m also not claiming that Jaffe is wrong.  What I am claiming is that Jaffe simply doesn’t offer sufficient backing for her argument.

God and mammon both teach fairness

Michael Giberson

In a study encompassing several distinct populations, Joseph Henrich and collaborators conclude that both participation in markets and belief in a world religion promote fairness norms that facilitate emergence of large-scale societies.  The study was described in a recent issue of The Economist:

For the evolutionarily minded, the existence of fairness is a puzzle. What biological advantage accrues to those who behave in a trusting and co-operative way with unrelated individuals? And when those encounters are one-off events with strangers it is even harder to explain why humans do not choose to behave selfishly. The standard answer is that people are born with an innate social psychology that is calibrated to the lives of their ancestors in the small-scale societies of the Palaeolithic. Fairness, in other words, is an evolutionary hangover from a time when most human relationships were with relatives with whom one shared a genetic interest and who it was generally, therefore, pointless to cheat.

The problem with this idea is that the concept of fairness varies a lot, depending on which society it happens to come from—something that does not sit well with the idea that it is an evolved psychological tool. Another suggestion, then, is that fairness is a social construct that emerged recently in response to cultural changes such as the development of trade. It may also, some suggest, be bound up with the rise of organised religion.

Joseph Henrich at the University of British Columbia and his colleagues wanted to test these conflicting hypotheses. They reasoned that if notions of fairness are, indeed, calibrated to the Palaeolithic, then any variation from place to place should be random. If such notions are cultural artefacts, though, they will vary systematically with some aspect of society….

The results back a cultural explanation of fairness—or, at least, of the variable levels of fairness found in different societies. … People living in communities that lack market integration display relatively little concern with fairness or with punishing unfairness in transactions. Notions of fairness increase steadily as societies achieve greater market integration. People from better-integrated societies are also more likely to punish those who do not play fair, even when this is costly to themselves….

Dr Henrich also, however, found that the sense of fairness in a society was linked to the degree of its participation in a world religion. Participation in such religion led to offers in the dictator game that were up to 10 percentage points higher than those of non-participants.

World religions such as Christianity, with their moral codes, their omniscient, judgmental gods and their beliefs in heaven and hell, might indeed be expected to enforce notions of fairness on their participants, so this observation makes sense. From an economic point of view, therefore, such judgmental religions are actually a progressive force. That might explain why many societies that have embraced them have been so successful, and thus why such beliefs become world religions in the first place.

So there you have it: both belief in world religions and participation in markets seem to be associated with fairness.

The Henrich et al. study was published as “Markets, Religion, Community Size, and the Evolution of Fairness and Punishment,” Science (March 19, 2010).  As summarized in the abstract:

Large-scale societies in which strangers regularly engage in mutually beneficial transactions are puzzling. The evolutionary mechanisms associated with kinship and reciprocity, which underpin much of primate sociality, do not readily extend to large unrelated groups. Theory suggests that the evolution of such societies may have required norms and institutions that sustain fairness in ephemeral exchanges. If that is true, then engagement in larger-scale institutions, such as markets and world religions, should be associated with greater fairness, and larger communities should punish unfairness more. Using three behavioral experiments administered across 15 diverse populations, we show that market integration (measured as the percentage of purchased calories) positively covaries with fairness while community size positively covaries with punishment. Participation in a world religion is associated with fairness, although not across all measures. These results suggest that modern prosociality is not solely the product of an innate psychology, but also reflects norms and institutions that have emerged over the course of human history.

If you have questions about how the study was conducted, how they measured market integration and fairness, etc., check out the extensive supplemental information also posted at the Science website.

High bills lead couple to file smart meter lawsuit against Oncor

Michael Giberson

Elizabeth Souder, the Dallas Morning News, reports on a lawsuit filed against Dallas-based wires utility Oncor claiming fraud and negligence associated with the company’s installation of smart meters.  The lawsuit can be viewed at the newly established website  The suit seeks class action status on behalf “all consumers in Oncor’s service area who have experienced significant increases in their electric bill since the installation of a “Smart” Meter system.”

Somewhat simplified, the lawsuit tells the story of a couple who say that their electric bills increased dramatically after Oncor installed a smart meter (reportedly from $400-$700 a month before, to as much as $1800 month after), the couple engaged in several attempts to get Oncor to disclose what was wrong with the meter and came away unhappy.

Other that the “post hoc, ergo propter hoc” argument and complaints about Oncor’s customer service, there isn’t much in the way of evidence in the lawsuit. I guess that is what the discovery procedure is for.  Admittedly, I don’t know the underlying facts; I’m just reacting to the appearance of a lack of merit in the lawsuit.

Maybe the message here is to install smart meters at the end of winter and the end of summer (adjusting as appropriate for local conditions).  That way, the first smart meter bills are likely to be lower than the last “dumb meter” bills. If consumers are going to leap to conclusions based on a too little data (and we will), you may as well have them leap to a conclusion in your favor.

HT to the Texas Energy and Environment Blog.

Georgia bill would add useful flexibility to price gouging law

Michael Giberson

A bill passed by the Georgia state senate would add some helpful flexibility to the state’s anti-price gouging law.  The primary purpose of the bill would be to allow the state to limit the range of items for which the price gouging rules will be enforced based upon the nature of the emergency.  For example, if a storm mostly damaged windows and roofs, the price gouging rule might be enforced on plywood and hotel rooms, but not on ice and gasoline.  Another part of the bill would allow gasoline retailers to raise the price of retail gasoline to reflect the cost of replenishing the store’s supplies rather than linking allowed retail prices to the historical cost of the gasoline sold. Currently the state allows “replacement cost pricing” for plywood during declared emergencies, but gasoline price increases were evaluated with reference to pre-emergency historical cost.

I’d rather see the state repeal its price gouging laws altogether.  The laws probably create more costs than benefits, and can lead businesses to shut down during emergencies rather than risk violating anti-price gouging laws.

From the Atlanta Constitution-Journal, “Bill allows gas price increase in emergency“:

Less than two years after hurricanes brought a run on gas, the state Senate has passed legislation letting station owners charge much higher prices as soon as an emergency is declared.

Officials with the Governor’s Office of Consumer Affairs worry the measure, if it becomes law in its current form, would make it tough to prosecute a gas station for price gouging.

“I think it would be very difficult to determine that price gouging had occurred,” said Bill Cloud, spokesman for the office. “I don’t know that we would have confidence in saying that, as the bill exists right now, we would be able to define, or describe or enforce price gouging as it relates to petroleum products.”

The bill was originally meant to give the governor more flexibility in deciding which products would fall under gouging laws during an emergency. For instance, if an emergency involved damage to homes but not a disruption in the flow of gas, gouging laws could apply to plywood or building materials and not fuel.

However the bill, which was backed by Gov. Sonny Perdue, was rewritten by the Senate Agriculture and Consumer Affairs Committee to allow stations, in an emergency, to charge for gas what they decide it will cost to replenish the fuel they have on site.

Meanwhile, one committee of the Connecticut state assembly unanimously approved a bill which offers a “mathematical definition that the state would use to identify gas station price gouging subsequent to natural disasters.”

“In the past, gas dealers have had trouble knowing what constitutes an emergency and what the definition of gouging is,” [State Rep. Jim] Shapiro said. “So the current provisions against gouging have been tough to enforce. This new anti-gouging provision clarifies the rules to provide consumers and businesses information to act accordingly when there is problems.”

Clarity in the law is usually a good thing – in order to comply with the law, businesses need to be able to tell what level of price increase will constitute a violation of the law.  But, as an industry spokesman stated, “the devil is in the details.”

In this case the bill declares it will not be a violation of the price gouging law if a retailer’s average margin during the “abnormal market disruption” is no higher than the maximum margin during the 90-day period prior to the beginning of the market disruption.  Because the definition is in terms of changing margin rather than changing prices, it may allow retail prices to track changing wholesale costs.  However, the bill fails to clarify whether the relevant rack price is the historical rack price paid at the time of the initial wholesale gasoline purchase, or a contemporaneous rack price at which replacement fuel could be acquired. The historical cost method would restrain price increases and hamper market adjustment more, the contemporaneous rack price method would restrain price increases and hamper market adjustment less.

Once again, probably an improvement over the existing state of affairs, but I’d rather see Connecticut repeal its price gouging laws altogether, too. As with Georgia, the Connecticut law probably creates more costs than benefits.

Incentives for efficient use of storage in electric power systems

Michael Giberson

In the most recent Energy Journal, Ramteem Sioshonsi has an article examining the welfare effects of the incentives to use energy storage in electric power systems. (“Welfare Impacts of Electricity Storage and the Implications of Ownership Structure,” See volume 31:2 here.) He considers the incentives faced by consumers, generators, and merchant energy storage owners (companies lacking consumer or generator affiliates).

His theoretical analysis demonstrates:

[W]elfare-maximizing storage use benefits consumers while reducing producer profits, [and therefore] will result in consumers and producers having vastly different incentives to use storage from one another and from merchant storage owners.  This is because the three different agent types will use storage to maximize their net payoffs. In the case of consumers this would consist of the sum of arbitrage value and consumer surplus change, whereas producers would maximize the sum of generation and arbitrage profits.  Merchant storage operators, on the other hand, will maximize arbitrage profits only.  Because consumer surplus is enhanced by welfare-maximizing storage use, and since consumers that own storage would not consider the impact of storage use on generator profits, they will tend to have an incentive to overuse storage.  Conversely, because storage use reduces producer profits, generators will have an incentive to underuse storage.

A numerical analysis based loosely on ERCOT system characteristics in 2005 provides further elaboration of the model.

Our numerical example showed that for most reasonable storage device efficiencies merchant ownership of storage is welfare-maximizing compared to the alternatives of consumer or generator ownership….  When storage assets can be divided amongst agent types the socially optimal allocation of storage favors merchants, although some consumer ownership of storage can be beneficial since their overuse of storage can compensate for underuse by merchants.

Sioshonsi observes that as the number of storage operators increases, overall use of storage capability approaches the social welfare maximizing outcome.  This is, of course, the familiar effect of competition in markets on welfare.

Reading this paper I couldn’t help but think of the Tres Amigas proposal, which I think would be the first merchant energy storage project of any significant size if built. (Am I overlooking any large grid-connected merchant energy storage projects?)  While this article was far from an analysis of the welfare consequences of building the Tres Amigas project, it does suggest that the project’s storage capability would offer substantial public benefits.

Sioshonsi only considers use of energy storage to buy and sell energy, but grid-connected energy storage can also be used to provide transmission support services (generally called “ancillary services”).  When energy storage gets built as a transmission-system component and factored into regulated transmission rates, regulations tend to prevent that energy storage from being used for energy price arbitrage.  So, “transmission-system” energy storage assets will be underused relative to the public interest.  But markets for ancillary services are incomplete, meaning merchant incentives to supply ancillary services may also be underdeveloped.  Most of the regional, integrated power markets (i.e. RTOs) have substantially improved their ancillary services markets over the past several years, and the way forward here is to continue to improve ancillary services markets.

ASIDE: Sioshonsi also notes that an integrated utility with consumer loads and its own generation assets may inherently favor the socially optimum welfare use of storage assets, “since these entities would be concerned with both producer and consumer surplus.”  However, this expansive claim is just an add-on remark in the conclusion not examined in the body of the paper.  Suffice to say that if the interests of integrated utilities were always aligned with both producer and consumer surplus, we could dispense with both restructuring and regulation and let consumers live in the warm embrace of unregulated, integrated monopoly power companies.

Power exchange regimes in Europe

Michael Giberson

At the EU Energy Policy Blog, Leonardo Meeus discusses the current organization of power exchanges in Europe. Meeus describes both private merchant exchanges and state regulated exchanges and notes the differing incentives of the two types, focusing on the effects on efficient cross-border exchange.

Meeus’s post draws from his recent working paper, “Why (and How) to regulate Power Exchanges in the EU market integration context.”

Ohio cities to end natural gas purchasing initiative

Michael Giberson

Via Tim Haab at Environmental Economics, a news story from The Columbus Dispatch reporting that five Columbus suburbs were ending a program in which the communities bought gas on behalf of residents that didn’t opt for another supplier.

“There’s really not a need for government to be in it,” said Dana McDaniel, Dublin’s assistant city manager, who announced the decision yesterday.

In May, The Dispatch reported that the group’s prices were often higher than those of Columbia Gas of Ohio, the regulated utility. The fixed price was set each year and stayed the same for 12 months, while Columbia’s price changed every month.

Some residents had voiced concerns that the group’s fixed-rate prices were too high and that the opt-out system for enrollment was confusing.

One of those residents, Barbara Drobnick of Gahanna, withdrew from the program in December after finding out that she had been automatically enrolled. Yesterday, she said she was pleased to hear the program was being discontinued.

“I like that they’ll be doing what cities are supposed to do, rather than making deals with private companies on my behalf,” she said.


Since the consortium began in 2005, its price was higher than Columbia’s in 43 out of 63 months, according to a Dispatch analysis of pricing and consumption data. Customers who had the city group plan that entire time and had average gas usage would have paid nearly $800 more than if they had gone with the utility.

It is a bit unfair, as McDaniel said later in the article, to compare the 12-month fixed rate price in the program to monthly variable price deals offered by Columbia.  A fairer comparison would look at what other 12-month fixed rate plans were offering at the same time the five-city group renegotiated each next year’s rate.

But I tend to agree with the McDaniel’s line quoted above, “There’s really not a need for government to be in it.”