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Bubble, Bubble, Oil and Trouble

Posted by | July 25, 2009

Last summer it took well north of $100 to fill the tank of my beloved 1987 pickup. You may remember, too, having to adjust your household budget in light of sky-high gas prices.

There’s a case to be made that the spectacular spike in petroleum prices last year was simply a financial bubble, not unlike what occurred in real estate in the previous years. When crude prices more than doubled – and then collapsed months later to their lowest prices in years – both American motorists and oil companies found themselves with widely unpredictable prices for a vital commodity.

Now, this summer, you’ve noticed the price of gasoline at your local pump is much higher than last Christmas. What’s the deal?

Geologists, roughnecks and engineers work hard every day to produce petroleum and refine it into gasoline and diesel. Just like you, we geologists were taught about supply-and-demand in school, and we want to believe that if we produce as much petroleum as we can, prices should remain reasonably predictable. But last year, when petroleum prices went sky high, worldwide supplies of crude were actually pretty strong, and that’s again the case now. Strong supply shouldn’t equal rapidly climbing prices.

A lot of people make money when bubbles are growing. But using financial instruments that allow large institutions to “bet” on price changes in either direction, up or down, big players can also make money when bubbles collapse. Some folks, including innocent third parties, can get clobbered along the way.

Crude oil is a commodity – like wheat. Major companies trade “futures” for commodities, which I think of as bits of paper promising to buy or sell a commodity in the future at a specific price. Futures markets like the New York Mercantile Exchange are meant to help everybody adjust to changes in supply and demand in a smooth way. Farmers can get a better idea of the price they’ll get at harvest by looking at the futures trading of corn, and mining companies can do the same for copper.  Futures are highly useful devices in many industries.

Major institutions have long invested in commodities to diversify their risk. But in recent years, the futures market for oil has attracted more and more dollars from investors who neither produce nor use petroleum.  My own alma mater, Harvard University, has been investing part of its endowment in commodity futures. Even though Harvard doesn’t want to ever take delivery of crude oil, it may buy and sell such futures in big chunks, as the television program “60 Minutes” has reported.

Major banks, investment firms and philanthropic institutions with endowments have been in the energy futures market for a number of years. Indeed, dollars from such institutions generally dwarf the dollar figures coming from companies that actually produce or consume the goods in question. That’s right, there are more folks “betting” on the price of oil than there are folks actually producing and buying the stuff. That’s not a reassuring picture to me.

All I can offer as a geologist to this financial picture is some basic natural limits. The evidence is plain: petroleum is going to become scarcer and more difficult to produce in the coming decades because we have used up the top “half” of the Earth’s oil barrel, the part that’s easiest to reach and pump. That means that if supply were our only issue, petroleum prices would rise over time as the rest of your life unfolds. It would not mean sky-high prices this week, nor this year, nor indeed at any time while the world wallows in this substantial recession. But fairly gradually over time, the price of gas “should” go up.

But what will happen to the price of petroleum in the next year or two will – very likely – be much more dramatic than that picture. And that’s tough for business and household budgets alike.

Everything about oil is complex, ranging from estimates of how much we geologists can still find in the Earth to American foreign policy in the Middle East. I think we’re also faced with clear evidence that investments in the crude oil market add substantially to price volatility.

Hang onto your hats.