Oil Prices & Bubbles

Today the CEOs of 12 major US airlines sent a single letter to Congress to ask it to reign in under-regulated speculation which they believe is one of the reasons for the recent run-up in the oil price that is affecting the global economy.

While opinions are abound on what is wrong with the oil market, it does appear to come down as the failure of a number of elements that have this combined effect. As with many system failures of catastrophic impact it usually takes the summary of multiple problems to make it happen. Today's systems, whether it is a computer or our economy has enough safe guards to deal with single failure points, but not always with multi-point failures.

So what are the failures in the oil market?

1. Supply & Demand Imbalance - A number of the worlds biggest economies, mainly India and China, but also other smaller ones are developing at a rapid pace. In the process they're developing a hunger for energy that is not dissimilar to what the US has gone through decades ago. The result is rapidly growing demand which is not matched by equal growth in supply. For several years now the margin in the world wide oil market capacity has hovered in the single digit percentage points. The supply is further hampered by a healthy dose of environmental concern which has limited development of some of the more intrusive oil supplies, further tilting the supply & demand balance towards the extreme of demand. That is true not only for the raw oil industry but also the refining industry which hasn't built a new refinery in the US in several decades. There is a lot of NIMBY attitude going on.
2. Political Struggles - The inability of the world's political leaders to solve the tensions in the Middle East has left much of that region in a state of tension and disrepair as it comes to oil supply. At the same time a significant amount of oil supply in other regions is controlled by regimes who have found appetite in playing outcast roles on the global stage and flexing their oil muscle in the process, causing extra uncertainty in the market that does not have enough margin to prevent even the slightest jitters from affecting the mood.
3. Ineffective Energy Policy - When there are no economic incentives to develop energy independence, the natural tendency of the consumer and free market players will be to ignore it. The inflation adjusted extremely low cost of energy in recent times has allowed the various energy consumers to go on a consumption binge. Unfortunately it takes a lot of time and money to turn that ship. It's more like a super tanker (no pun intended) then a canoe. Millions of American consumers have gas guzzling SUVs which are still tied up in car loans that are under water, and prevent people from selling them for smaller, more fuel efficient cars, even if the market were able to produce sufficient supply of replacement, which is not the case either. It would have taken the forward looking thinking of real leaders to create the right policies that would have provided the right incentives to balance this picture ahead of time.
4. Speculation - It does appear that a lot of trading in the energy market right now is driven by investment funds that actually have no stake in the oil other than it is a place to make money. That in turn is adding significant pressure to an already stressed market. It is this speculation that the letter from the airlines is targeted at. But to be realistic, our global economy has an enormous supply of investment funds always in search of an attractive target. Because the supply and demand of the investment wealth is tilted towards the supply side, there is always one element of our global economy that is in a 'bubble' status, exploiting some form of unrealistic exuberance and willingness to ignore market fundamentals. In the late '90s it was the dot-com boom that his money chased. Once that crashed, the money chased the housing market. Which has since crashed. So the oil market was the next logical thing for the bubble to gravitate to. Ultimately in this global economy there is only one thing to burst a bubble - give it a new shiny object to chase.

So in summary, this is a complex multi-point failure in the global system. There won't be any easy and quick fixes for it. But it will be a piece of our history, with its share of law suits and text books written about it.

And in the end it will not end until the next disaster comes along. This can be easily observed in the news coverage, which gives over proportional attention to a single subject of crisis. For months one couldn't listen to the TV or read news sites on the Internet without being bombarded on the credit crisis. Is it over? No. Is in the same proportion to the extent it still exists on the air? No, because the oil prices are the disaster du jour.

Update on 9/13/2008:

Per the following story in the Seattle Times it's now much better understood just how much of the price run-up can be attributed to speculation.