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.

4 thoughts on “Crude Oil Prices in 2008: Was the Spike a Bubble?

  1. Mike–

    Don’t have a lot of time, so more later. But a couple of quick hits.

    First, as Phil Verleger pointed out repeatedly during this period, WTI and Brent spiked relative to other grades (e.g., heavy Iranian crudes) due to the the new regs on clean diesel in Europe and production disruptions for light crude in Nigeria. Available data lumps all crudes together, which obscures our ability to examine supply and demand balance for specific types, and makes it difficult to evaluate the economics.

    Second, I’ve shown that in periods of heightened fundamental uncertainty, stocks and prices can both rise. Fundamental volatility shocks make it more desirable to hold inventory. The only way that inventory can expand in response to such shocks is for consumption to fall and/or output to rise, both of which require higher prices. Thus, although a positive co-movement in stocks and prices may be a necessary condition for manipulative distortion, it is not a sufficient one. (This will be a chapter in my forthcoming book. Working paper is available.)

    Third, there were price spikes in myriad commodities in 2007-2008. A focus on oil can be misleading. I’m currently doing a paper which shows that inventory and price movements for a variety of commodities were not symptomatic of a bubble, and indeed, prices of some thing that CANNOT be a bubble (i.e., shipping rates) were rising dramatically at the same time.

  2. All good points, but the third is perhaps easiest to see (so long as an energy economist is willing to be open-minded enough to actually look at non-energy commodities. How often we forget…).

  3. An update: I’ve used a kernel smoothing (local quadratic) regression to capture seasonality in oil stocks, based on US data from 2001-2009 (what I had at hand). During the initial runup in oil prices, mid-07-early-08, oil stocks went from about 36mm bbl above the seasonally adjusted average, to 17.6 mm bbl below the seasonally adjusted average. In January, 08-April 08, stocks rose, but to just about their seasonally adjusted average (at the maximum, about 2mm bbl above the average). Then, stocks declined, reaching their (local) minimum of 25 mm bbl below the seasonally adjusted average on 4 July, 2008–exactly when prices reached their maximum. Then stocks began to increase, and prices to fall. By May, 2009, stocks were over 50 mm bbl above the seasonally adjusted average.

    This is not consistent with the bubble explanation. Indeed, it comports mainly with a fundamentals-based, theory of storage explanation in which for the most part price increases were associated with stock drawdowns, and price decreases with stock build. (Calendar spread data back this up.) Note that if prices were bubbling during 07-08, the bursting of a bubble should have led to a drawdown in stocks, but we see the exact opposite. This decline in prices and ballooning of stocks is best explained as a rational, efficient response to a large, unanticipated demand collapse.

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