by

June 2008

R.S. Eckaus

The Oil Price Really Is A Speculative Bubble

08-007

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 The Oil Price Really Is A Speculative Bubble 

R.S. Eckaus∗

June 13, 2008 

Abstract 

The oil price really is a speculative bubble. Yet only recently has the U.S. 

Congress, for example, showed recognition that this might even be a possibility. In 

general there seems to be a preference for the claim that the price increases are the 

result of basic economic forces: rapid growth in consumption, pushed particularly by the 

oil appetites of China and India, the depreciation of the U.S. dollar, real supply 

limitations, current and prospective and the risks of supply disruption, especially in the 

Middle East. These “explanations” will be taken up one by one, but first a view of what 

has happened to oil prices over recent years. 

I. Tracking the Oil Price 

 Chart 1 presents an authoritative set of data produced by the U.S. Energy 

Information Agency (EIA), averaging the current prices of different qualities of oil at 

different places, each given a specific weight according to its relative export volume. 

The Chart shows that, after being relatively stable at $25 or $30 dollars a barrel for a 

number of years, the price started to rise in 2004 and continued until after the middle of 

2006. After a drop of almost $20 a barrel in 2006, prices began to climb again and at a 

much faster rate. 

 

∗ Professor of Economics Emeritus, Department of Economics, MIT. Tel: (617) 253-3367. E-mail: 

eckaus@mit.edu
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Petroleum Prices

0

20406080

100120140

12/31/1999

4/30/2000

8/31/2000

12/31/2000

4/30/2001

8/31/2001

12/31/2001

4/30/2002

8/31/2002

12/31/2002

4/30/2003

8/31/2003

12/31/2003

4/30/2004

8/31/2004

12/31/2004

4/30/2005

8/31/2005

12/31/2005

4/30/2006

8/31/2006

12/31/2006

4/30/2007

8/31/2007

12/31/2007

Month/Year

Dollars per barrel

Chart 1

Source: U.S. Energy Information Agency (EIA)
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Although the influences behind price movements cannot be determined simply by 

looking at the price record, that record can be suggestive. Thus, it is tempting to believe 

that something big happened in 2004 to create a definite upward push to prices and then, 

again, in 2007. In 2007 and the first six months of 2008, something even bigger was 

pushing up prices even more rapidly. What could the, “something big” be? A powerful 

demand push? A major supply constraint? Or, the suspicion must emerge, that the price 

movements in 2007 and after look suspiciously like other speculative price movements. 

Think pork bellies. 

II. Oil Demand 

 We cannot pick out the constraining effect of prices on demand without doing a 

lot of careful statistical analysis, which is beyond the intent of this note. Still it is 

interesting and informative to look at demand growth. That is shown in Chart 2, based on 

International Energy Agency data, which records the growth rates of world demand and, 

separately, those of China, which, it has been argued, are pushing the world oil price. 

 There was a growth in total demand from 2002 to 2004 pushed by more rapid 

growth in the Chinese demand during that period. Since 2005, the rates of growth in 

world demand and Chinese demand have actually fallen substantially. The annual 

increases in world oil demand have been about 1.5% and the growth in Chinese demand 

has fallen since its peak in 2004 to about 5.3%. It is possible that the demand pressures 

in China have been constrained only by the dramatic price increases. Yet the 
4

Growth in Oil Demand - World Wide and China

02468

1012141618

2001 2002 2003 2004 2005 2006 2007 2008 2009

Year

Growth Rates in Per Cent World Demand Grow

China Demand Grow

Chart 2

Source: International Energy Agency
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 facts refute that. While domestic and foreign oil prices in China have risen along with 

international oil prices, gasoline prices to consumers have hardly moved, as a result of 

government subsidies. On the 28th of May of this year, gasoline in China was $2.49 a 

gallon, as reported in Forbes. So one cannot give credit to the higher oil prices for 

holding down growth in Chinese consumption. 

III. The Effect of Dollar Depreciation 

 The depreciation of the U.S. dollar has been used as another explanation for the 

increase in oil prices in dollars. This is an easy argument to dispose of. The dollar has 

depreciated by about 9 per cent against the Euro since 2004, when oil prices began their 

strong upward move. So it would have taken just a 9 per cent move of the oil price in 

dollars to have preserved the purchasing price in Euros of a barrel of oils. Since that time 

the price of oil in dollars has, roughly quadrupled. 

IV. The Danger of Political and/or Armed Disruptions in Oil Supply 

 This is a more difficult argument with which to deal as there can be plausible 

differences in political and strategic assessments. However, if the argument is to hold, 

there must have been a drastic change in the prevailing assessments in 2004 and a still 

more dramatic change in 2007, when oil prices began to climb at an even faster rate. 

 The Middle East, in particular, seems always to be in some kind of turmoil so that 

excuses can be always be found for pessimism. Yet there have been no new major, 

recent threats to stability. It might be argued that the tensions between Iran and the U.S. 

and saber rattling by Israel have increased the worries about the possibility of Iranian 

supply disruptions. Iran, itself, needs all the dollars and Euros it can earn from its oil to 

support its economy. And Iran has never seriously threatened an oil embargo. In fact Iran 

is investing in new oil fields in order to increase its supply and plans to increase oil 
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production by 1 million barrels per day, an almost 20 per cent increase. It is striking that 

this has had no effect on prices. 

 A strong recent signal of potential moderation of Middle East tensions has 

occurred in the past month. That is the apparent real interest of Israel and Syria in 

diplomatic discussions of the moderation of the tensions between them by exchanges of 

land by Israel and commitments by Syria to reduce its support for Hezbollah in Lebanon. 

This signal has been ignored by the oil price. 

 Short of a virtually complete shutdown of Middle East oil production, no 

plausible price elasticity of demand would justify the quadrupling of oil prices. The 

possible effect of political and military tensions in raising oil prices cannot be proved. 

Neither can it be disproved, although more evidence could be assembled than could be 

presented here. Nonetheless, there are enough obvious facts to raise questions as to its 

relevance. 

V. The World is Running Out of Oil, Now or Later? 

Could near term supply constraints could be responsible for the price increases. 

The International Energy Agency publishes data not only on OPEC production but also 

on its, “spare capacity,” which is the difference between its, “sustainable capacity,” and 

actual production. In February of 2008 that spare capacity was just slightly less than 10 

per cent of its actual production. That was lower than the spare capacity in 2001 and 

2002, but higher than that in 2004, 2005 and most of 2006. It is a comfortable cushion. 

The final argument that has been made for the increase in oil prices is that the 

world will run out of oil at some, not too far distant date in the future. The threat is that 

at some point there will simply be no more oil to be pumped out of the ground or so little 

that prices must rise substantially to ration what little there is. This argument seems to be 
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only a matter of common sense: there must be a limit to what oil there is under the 

ground. 

Finding the limit, whatever it is, depends on the investment in exploration and 

pumping. The U.S. Energy Information Agency estimates that proved oil reserves have 

been increasing at about 2.5 % per year since 2004, faster than the rate of increase in oil 

consumption. Second, the oil supply does not depend only on what can be pumped out of 

the ground. The oil sands of Venezuela and Canada and the oil shales of the U.S. are 

potentially enormous reserves, larger than the underground oil reserves. The oil sands 

are expensive and the costs of getting the oil are increasing, but the breakeven barrel cost 

of a current project, was estimated at just $14.50 a barrel in the Energy Bulletin, far 

below the current price of underground oil. 

 Moreover, ethanol from sugar cane and corn is now a practical oil substitute. It is 

true that price in the U.S. of ethanol from corn is rising as the value of its food use is 

increasing. However the ethanol price in the U.S. is politically determined by the quotas 

and tariffs that the U.S. imposes on Brazilian ethanol from sugar. If those were removed, 

the price of ethanol and corn would fall. 

 Suppose that there is a specific limit to oil reserves. What current price would that 

justify? A common valuation method, known as Hotelling’s Rule, says, if there are good 

markets, the price of the reserves should rise at the rate interest, assuming the cost of 

raising the oil should remain constant. The reasoning is simple. Oil is an asset like, say 

U.S. Treasury bonds. Putting aside any risk premiums, holding the oil asset should be 

equivalent to holding the bonds and, therefore, must yield the same rate of return. Since 

oil reserves do not pay interest, there must be an annual increase in the oil price that is 

equal to the rate of interest. Subsequent analysis suggests that his rule overvalues oil 
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reserves and a more accurate rate of increase in oil reserves would be about one-half the 

going interest rate. 

 The rate of increase in oil prices has been much, much higher than either 

approach would warrant, so it is difficult to justify the rapid increase in oil prices by 

referring to a judgment that oil may, “run out,” in the future. 

VI. The Oil Price is a Speculative Bubble

 Since there is no reason based on current and expected supply and demand that 

justifies the current price of oil, what is left? The oil price is a speculative bubble. 

 This is an idea that has some backing in financial circles, e.g. George Soros. The 

spiking price pattern would, itself, suggest it. It is well known that hedge funds are very 

active in the oil market and their activity, along with other speculators, has raised the 

volume of oil transactions far above the volume warranted by ordinary commercial 

transactions. 

 Have the rapid price increases lasted so long that the impetus cannot be just 

speculative? Well speculative bubbles can last a long time. Think of the dot com bubble 

or the bubble in housing prices. 

 Is a speculative bubble irrational? No, it is rational to ride along and trade in a 

speculative bubble as long as it is expanding. The moment of truth comes only at the 

end, when the bubble bursts. 

 It might be expected that if the prices were a speculative bubble that would lead to 

an inventory build up, especially as there is spare productive capacity. There are two 

reasons why that has not occurred. First, inventory capacity is relatively low. Second, 

the agreement in the OPEC cartel to limit production has been successful and non-cartel 

members have implicitly consented to go along. 
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 What could bring the bubble to an end? Anything that changes future price 

expectations... For example, a strong dose of reality. It could come in several ways. If 

one of the important oil producers should announce an increase in its production, the 

announcement itself might break the bubble. Suppose a U.S. president announced that the 

oil prices were creating an emergency economic situation that justified using the Strategic 

Petroleum Reserve. Then allocations from that reserve were made. That could break the 

bubble, perhaps even before the actual allocations. It might be enough if the U.S. 

president just announced that there was really no energy shortage and the oil price 

increases were just speculation. Analogously, “open mouth” tactics on the part of the 

president of the chairman of the Federal Reserve are a recognized tool of monetary 

policy. 

 There is no doubt that the speculative bubble is having real effects. Just ask a 

commuter, a trucker or an airline customer and many production and commercial firms... 

So efforts to break the bubble are warranted.