Double-Bubble, and Oil, and Trouble

Commentary, Energy, Owen McShane

Now that the oil bubble seems to be deflating alongside the housing/finance “double-bubble,” many people are wondering whether the oil bubble was driven by speculators or by real issues of supply and demand. Having commented on housing bubbles for the last ten years, I have learned something about the behaviour of bubbles, and why they inflate and why they burst.

One of the first lessons is that the response to any particular bubble is determined largely by whether a person is on the winning or losing side of the boom.

For example, those who find themselves priced out of the housing market tend to blame “greedy property speculators and developers” who “obviously” drove up prices or they take out their anger on the “greedy banks” for lending too readily and far too cheaply. (Who would be a banker? Lend at high interest rates and you are a usurer. Lend at low rates and you recklessly fuel inflation.)

On the other hand, those who suddenly become housing millionaires; those who sell advertising in real estate supplements; councillors who drag in levies, fees and rates; and real estate agents who buy and sell at ever-increasing prices are easily persuaded that rising house prices are driven by natural increases in demand.

Those who pointed out that constraints on the supply of residential land and excessive compliance costs were driving a bubble that must soon burst were given short shrift by almost everyone, especially the central planners and politicians who were implementing the constraints and charging the development levies.

The same thing happened with the oil bubble. Those who faced higher living costs and rising costs of doing business soon became convinced that “greedy speculators” were driving oil prices through the roof and that multinational oil companies were colluding to rip off their customers. Furthermore, those who believe fossil fuel users are destroying civilization and taking the planet down with them revel in the prospect that “peak oil” syndrome will drive prices ever further through the roof and force laggard economies to make the transition to renewable “carbon-neutral” energy sources.

The real winners just kept on building Dubai and similar kingdoms in the sun.

Most people are probably somewhat, even if reluctantly, self-aware of this bias in shaping their attitudes to booms and bubbles. However, popular attitudes to speculators and speculation are more complex.

Many tend to regard “rampant speculation” as a nasty practice carried out by greedy people who benefit from an unfair advantage.

However, if those same people pay $100 for a painting by a young artist who goes on to become a famous name, and then they sell it at auction for $10,000, they do not describe themselves as speculators in the art market. Rather, they see themselves as connoisseurs who have exercised good taste and judgment. Similarly, we do not label the people on the Antiques Roadshow as speculators. Surely, they are ordinary, honest folk who have hung on to their heirlooms for some time and who have no interest in what their antiques are worth even though they line up to get them appraised on TV.

However, there is some sweet reason here. People usually reserve the term “speculator” for someone whose participation in the market can actually affect the price, usually by driving it upwards, to his or her benefit and, presumably, to everyone else’s cost.

Of course, this is not the economist’s definition, and we should be aware of the beneficial role legitimate speculation plays in promoting the efficient operation of markets. But, this essay is exploring the attitude of lay people toward speculators and their role in driving the boom and bust cycles in oil, housing and other markets.

These attitudes will tend to determine whether a person decides the oil bubble was driven by speculators or by real issues of supply and demand. Now that the oil bubble appears to have burst, many commentators who were convinced peak oil was at work are tending to the view that speculators were to blame all along, which is par for the bubble course.

Although I am keenly aware that Lyndon Johnson longed for a “one-armed economist,” I, too, will have to say, on the one hand, that speculators have been at work and have affected prices, but, on the other hand, real issues of supply and demand have influenced their actions.

The history of bubbles suggests this is always the case.

The famous tulip mania, or tulipomania, which began around 1600 and finally burst in 1636, was driven primarily by fashion that soon became fad that then fed widespread expectations of a never-ending rise in prices. The supply was initially constrained by the limited number of bulbs. Gardeners responded to the explosive increase in demand by inventing the first commercial nurseries, and they were soon supplying tulip traders right across Europe. These new nursery entrepreneurs soon developed new tulip varieties that created a new round of scarcity and a new surge in prices. While a popular childer bulb was worth 1,615 florins, the new Semper Augustus was “cheap” at 5,500 florins. At that time, 480 florins could buy four fat oxen.

This speculation was financed by the new-found wealth from the commercial activity that developed spectacularly during the Elizabethan era, and tulip speculation was funded by asset sales and borrowing. Things change and things remain the same.

Suddenly, tulips went out of fashion, the bubble burst, and vast fortunes were lost, as virtually overnight even the most prized bulbs fell to 10 per cent of their previous value. By the end of the collapse, bulbs worth the equivalent of $120,000 had fallen to $3. However, the Dutch economy was robust enough to survive, and tulipomania probably contributed to the development of commercial enterprises, stock markets and financial institutions that soon made the Netherlands the richest country in Europe. Tulips continue to make a substantial contribution to the Dutch economy, supporting a $5-billion industry that employs more than 90,000 people.

The 1772 South Sea Bubble – which gave such enthusiasms their name – was so outrageous that we have little to learn from it except that there is evidently no limit to human folly.

The dot com bubble that inflated from 1995 to 2000 was driven by feverish speculators in the new Internet industry who were all investing in the few commercial vehicles with .com at the end of their names. Thousands of nerds and geeks soon learned to invent new dot com companies to meet the surging demand. Venture capital financing to fund the speculation became widely available, just like the subprime lenders yet to come. The dot com investors were all convinced they had identified the few apples among the multitude of lemons. The bubble burst and the 2000 recession began. Low interest rates were blamed for this bubble, too. This was not the first technology bubble – and it will certainly not be the last.

As the dot com bubble deflated, the housing bubble was born. Al Gore made urban sprawl a top issue in his 2000 presidential campaign, claiming that smart growth would let Americans spend “less time stuck in traffic and more time reading to their children.”

In reality, smart growth soon meant that Americans spent more time stuck in traffic, less time reading to their children and much more time at work trying to pay off the mortgage.

Smart growth deliberately restricted the supply of residential land, so naturally prices rose. The history of urban planning is essentially a history of one damn fool idea after another, and the theory of growth management or smart growth has probably been the most damn fool idea of them all and certainly the most damnably expensive. The inflated land prices boosted house prices, and, as always, the finance sector rushed in to service the demand for borrowings based on the new security available to anyone who owned a home in smart growth territory.

However, all bubbles burst, and house prices in the smart growth states such as California, Florida and Hawaii began to deflate rapidly in 2006, dragging the lenders down with them. The shock was soon felt around the world.

The finance houses, pension funds and private equity funds that had been lending recklessly to the inflating housing markets within the United States, Canada, Australia, New Zealand and the United Kingdom were soon looking for another home. Understandably, after these decades of fickle bubbles, they turned to the solid, boring and stable commodities such as gold, copper, iron, food and, of course, oil.

There have always been forward markets in commodities. Normally, these tend to stabilize prices rather than to create bubbles. However, just as with housing, there were some real and perceived supply and demand pressures working to increase the price of oil.

Many people, and especially the greens, were promoting the idea that we had reached the point known as peak oil – namely that oil production had peaked and would now track remorselessly down. They welcomed any consequent rise in oil prices as a powerful signal that would encourage the greedy consumers of the world’s resources to abandon fossil fuels in favour of renewables that minimize green house gas, and hence help “save the planet.”

Also, there was considerable instability in the Middle East, the Russians were prepared to use supply constraints as a bargaining tool, and many oil-producing nations of Africa and South America were volatile, to say the least. Refining capacity was stretched, and environmental laws and Kyoto commitments were making it difficult to build new refining capacity.

So, it was easy for speculators in the oil bubble to decide that real and ongoing constraints on supply would keep driving oil prices upward.

The economies of India and China were booming and demanding huge increases in supply of all commodities, particularly oil and coal. All the developed economies were continuing to grow and were increasing their use of oil and oil-based products such as plastics and fertilizer. It was easy for speculators to decide that these demand pressures would keep driving prices up.

The necessary condition for a bubble to develop is the general perception that prices will continue to rise – forever. The combination of apparently permanent supply constraints and an apparently permanent increase in demand made this a reasonable assumption. So, more money flowed in and the oil bubble inflated further.

Normally, an increase in price soon leads to both an increase in supply and a reduction in use.

However, the oil market is sticky, because so much of the supply of crude oil is in the hands of states that operate a cartel that sets the market price much higher than the price of oil at the wellhead. The profit margins for those who draw the oil out of the ground are massive.

It is generally agreed that many secondary sources of oil such as shale and oil sands become worth mining if oil reaches around $100 dollars a barrel. These sources require massive investments, and if alternative-oil entrepreneurs began to supply oil in sufficiently serious quantities to reduce the dominance of regular crude, the Middle Eastern suppliers, in particular, could simply drop their prices – down to $20 a barrel if necessary – and put the alternative-oil sources out of business. Consequently, people are unwilling to invest in these technologies until they are confident that $100 a barrel oil is a long-term minimum price; few have been prepared to make that wager.

Furthermore, environmental regulatory barriers dramatically reduced the ability of the developed nations to explore for oil in their wilderness territories or to drill offshore.

For a few years, it seemed the oil bubble was well founded and prices would keep going up and up and up.

So what went wrong – for the speculators, and the greens?

We have to remember that bubbles are driven by perceptions, and perceptions can literally change overnight, as happened with tulip mania.

First, rising prices do affect demand. The Americans drove 120 billion fewer miles last year than the year before. Better management of mobility achieved most of this reduction. Only about 2-3 per cent moved to public transport – which in many inefficient cases only increased fuel consumption.

This mobility management and other conservation and efficiency activities translated into a 4 per cent reduction in fuel consumption by the transport sector. This is a significant drop in one year and must have changed a few perceptions about ever-increasing demand.

Then the United States began to make serious noises about “energy independence,” and legislators warmed to the idea of opening up Alaska and offshore drilling, which must have changed a few perceptions about long-term constrained or falling supply.

Possibly the biggest challenge to the perception of permanent price rises came from the multitude of proposals to either electrify the vehicle fleet or otherwise dramatically increase engine performance and overall vehicle efficiency. When product substitution combines with major efficiency gains and reduced driving patterns, demand can drop dramatically. In addition, concerns about perceived climate change were making nuclear power an acceptable alternative to fossil fuel. When the United Kingdom announced its plans to build 12 new nuclear power stations, many more perceptions about an ever-increasing demand for oil must have changed.

This short list is easily extended. Indeed, with every future change in price, commentators will compete to come up with novel explanations. But, even this list covers several groups of different mindsets and several groupings of economic and political interests, and it does not take many sell notices to start a new tide flooding over the affairs of men.

These or similar changes in perceptions meant that in 2008 oil prices fell by 21 per cent during the month of July. It may still be too early to be certain what the long-term trend will be and where the price will finally settle. However, it is hard to imagine a sudden reversal in the kinds of events, announcements and developments that triggered this sudden and dramatic fall in the price of oil. If anything, they are more likely to increase in scope and number.

It makes sense to refer to the housing bubble and the consequent frenzy of lending as a ‘“double-bubble,” because the two activities were in such a cancerous, symbiotic relationship. However, this short historical survey suggests that all real bubbles are double-bubbles. When any set of goods or services begins to rise in price, the financial sector responds to the explosive increase in the demand for loans and equity that are necessary to support the speculative spending.

All bubbles are double-bubbles and naming the banks as the sole cause of the housing bubble is rather like blaming the stock market for being the sole cause of the dot com bubble.

If there is anything to be learned from the recent string of bubbles, it may be that surplus investment capital, now floating round the world in cyberspace, is always looking for a speculative home and that as one bubble bursts, the fund managers desperately seek out a replacement.

Capital is now as mobile as the next damn fool idea.

If oil settles down, where will the reef fish find their new home?

Will we see a gathering flock to carbon trading, windmills, biofuels and other renewables driven largely by the legislators?

The traders in tulips were known as “wind traders,” because their fingers never touched the bulbs – let alone the good earth.

Will the next round of traders be speculators on the future price of hot air?