Explaining the oil price bubble — and bust

John W. Schoen Senior producer • Profile • E-mail

With oil prices down to roughly a third of peak levels last summer, OPEC oil producers met over the weekend to try to agree on cutting production to get prices back up again. So far, those efforts haven't succeeded.

If OPEC can't push oil prices higher, doesn’t that mean this year's price spike was driven by greedy speculators after all?

I know everyone is worried about the financial issues right now, but why isn’t anyone talking about the falling oil prices and speculation? It seems like just another "bubble" that burst. In retrospect was the recent run-up caused by people/organizations looking for a double-digit return, just like housing, tech stocks, etc.?
— Jim E., Chesapeake, Va.

Falling oil prices are a financial issue at the moment. The sharp reversal in oil prices — which recently fell below $50 a barrel after peaking at roughly three times that level less than six months ago — is adding to worries about deflation.

The concern is that the price drop, along with the continuing drop in housing and stock prices — could touch off a downward spiral that would severely hamper the government’s efforts to get the economy moving again. (You can read more about deflation here.)

It’s true that speculators helped fuel the price run-up when billions of dollars piled into the futures market trying to find big returns. The recent exodus of that money helped accelerate the collapse. But these investors didn’t cause the spike — nor did they burst the bubble.

Investors are a powerful force in commodity markets and, on balance, a positive one. If you’re buying or selling something — whether because you intend to use it or just trade it for a profit — you want to deal with as many buyers and sellers as possible. That’s true whether you’re trying to sell junk from your attic on eBay, or buy a house, or sell a stock. The more bidders, the closer you can get to a true “market” price — whether you’re a buyer or seller.

This only works, however, if the market is functioning properly. The current financial mess is a result of a breakdown in the markets that supplied money for home loans; the people making the loans bore no risk because they sold them to investors (who didn’t take the time to look closely at what they were buying).

The river of money flowing from this broken credit market washed over the housing market and lifted house prices to unsustainable levels. Now that the bubble has burst, the market is still broken; lenders won’t lend until they’re convinced they’ve seen the worst. As long as house prices keep falling, we’re not there yet.

Some readers suspect that when oil prices spiked, that market was also broken. And some members of Congress favor tighter regulations on futures traders. If evidence can be found that the oil spike was the result of a broken market, more regulations may be needed. But, so far, we haven’t seen any proof of that. (Please forward any evidence to the contrary.)

There are, however, much better explanations for the oil price spike and subsequent collapse. Strong global growth brought a surge in demand for refined fuels, especially diesel fuel needed to move goods and power the machinery behind a global building boom.

Demand for diesel fuel also played a role that got little attention during the run-up. A number of readers at the time wondered why diesel had become more costly than gasoline — a reversal of the traditional price trend. The reason was that in 2007 new air quality regulations required refiners to dramatically cut the levels of sulfur and produce so-called Ultra-Low Sulfur Diesel.

For most refiners, that meant using light, sweet crude, which is low in sulfur. Though overall crude supplies kept up with demand, much of the new crude coming to market was too sour (too high in sulfur) for diesel refiners. That added to the demand for light, sweet crude — the most widely used benchmark for oil prices. (Lower grades of crude sold for less.) Government purchases of light, sweet crude for the Strategic Petroleum Reserve tightened demand further.

Other factors played a role in this year's price spike. A falling dollar boosted the price of crude in dollar terms. Political tension between Middle East oil producers and Western consuming countries raised fears that crude might be used as a weapon.

Many of these trends have made an about-face in the course of a few months.

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