NUMBER PB09-19 AUGUST 2009

1750 Massachusetts Avenue, NW Washington, DC 20036 Tel 202.328.9000 Fax 202.659.3225 www.piie.com

The 2008 Oil Price “Bubble”

Mohsin S. Khan

Mohsin S. Khan has been a senior fellow at the Peterson Institute for 

International Economics since March 2009. Previously he was director of 

the Middle East and Central Asia department at the International Monetary Fund (IMF) from 2004 to 2008. He joined the IMF in 1972 in 

the Research Department, where he held several positions including deputy 

director, and in 1996 became director of the IMF Institute. Other affi liations include visiting lecturer and research fellow at the London School of 

Economics (1975–76), adviser to the Central Bank of Venezuela (1976), 

and chief of the Macroeconomics Division of the Development Research 

Department at the World Bank (1985–86). He has published numerous 

articles in major economics journals and edited several books, including 

Economic Development in South Asia (2005), Macroeconomic Management: Programs and Policies (2002), and Th eoretical Studies in 

Islamic Banking and Finance (1987). In 2003 he was awarded, jointly 

with Abbas Mirakhor, the Islamic Development Bank Prize in Islamic 

Economics for outstanding contributions to the fi eld.

Note: Th e author is grateful to Adam Bennett, C. Fred Bergsten, William 

Cline, Morris Goldstein, Gary Hufbauer, Aasim Husain, Gene Leon, A. 

Prasad, Abdel Senhadji, and John Williamson for very helpful comments 

and suggestions and to Christine Ryan and Daniel Xie for excellent research 

assistance.

© Peter G. Peterson Institute for International Economics. All rights reserved.

BACKGROUND

As oil prices began to rise in 2009 from a low point of about 

$40 a barrel in January to around $70 a barrel in July, a key 

question is whether the world is in for another oil price spike 

in the near term similar to that witnessed in early 2008. Several 

hypotheses were advanced when world oil prices started their 

inexorable climb from 2003–04 onwards, then skyrocketed 

from $92 a barrel in January 2008 to cross the $140 a barrel 

mark in June, fi nally hitting a record high of $147 a barrel 

on July 11, 2008, before collapsing to less than $40 a barrel 

in December (fi gure 1).1 Th ere was the “peak oil” explanation, based on the theories of M. King Hubbert of “Hubbert’s 

Peak” fame and his supporters, notably Colin Campbell and 

Matthew Simmons, that the world was running out of oil.2

Th ere were the market “fundamentalists,” including importantly John Lipsky, the fi rst deputy managing director of the 

International Monetary Fund (IMF), and Philip Verleger, a 

well-known oil expert, who argued that the fundamentals 

of demand and supply were primarily behind the extraordinary rise in oil prices in the fi rst half of 2008 (Lipsky 2009a, 

2009b; Verleger 2005, 2008). Interestingly, this fundamentals 

view was also shared by the US Treasury and was articulated 

by David McCormick, then undersecretary for international 

aff airs, in a presentation in July 2008 at the Peterson Institute 

for International Economics.3 Finally, there were those who 

maintained that such an increase could only be a “bubble,” 

unexplained by peak oil theory or market fundamentals. 

Many fi nancial-market participants were proponents of this 

third view, notably Michael Masters (2008), as well as the 

main oil producers, who were as surprised as anyone at the 

speed and size of the price increase over only a few months. 

Th eir argument was that the phenomenal increase in fi nancialization of commodity markets during 2006–08, including in 

particular the oil market, led to speculation and momentum 

trading, which pushed oil prices way beyond their long-term 

equilibrium level as determined by fundamentals.4

1. For convenience, oil prices in this policy brief refer to prices for West Texas 

Intermediate (WTI) crude.

2. A good description, albeit somewhat critical, of the Hubbert’s Peak theory is 

contained in the recent book by Leonardo Maugeri (2006), who extends and 

updates the seminal book on the history of oil by Daniel Yergin (1991).

3. See McCormick (2008). It is worth noting that the US Treasury view contrasts with the conclusions of a US Senate Staff Report in 2006 that blamed 

speculation for contributing to rising energy prices. See US Senate Permanent 

Subcommittee on Investigations (2006).

4. See Hamilton (2009a, 2009b) for a detailed long-run analysis of the 

behavior of crude oil prices examining the respective roles of peak oil (or 

“scarcity rent”), fundamentals of demand and supply, OPEC monopoly 

pricing, and speculation. While OPEC policies were certainly an important 

factor in the 1970s and 1980s, there is no evidence to suggest that the cartel 

was responsible for the more recent price increases as members were producing 

Policy Brief
NUMBER PB09-19 AUGUST 2009

2

LOOKING AT THE EXPLANATIONS

Developments in the world oil market in 2008 raise two 

important questions, answers to which have obvious implications for future oil price expectations.

 First, was the oil price increase of over 50 percent in the 

fi rst six months of 2008 a bubble?

 Second, if it was a bubble and oil prices overshot their 

long-term equilibrium level in the fi rst half of 2008, did 

they undershoot when the bubble burst in the second half 

of the year? 

To get a handle on the fi rst question, one needs to 

consider the two main explanations of the oil price increase in 

2008—the peak oil theory and the fundamentals theory. For a 

start, developments in the global oil market have not validated 

the peak oil theory. In the early 1970s, M. King Hubbert 

projected that world oil production would peak in the mid1980s and then decline to 35 million barrels a day (mbd) by 

2000 (Maugeri 2006, 213–15). Th is projection was clearly way 

off the mark as total world oil production in 2000 was around 

at close to full capacity from around 2002 and particularly in 2007–08, when 

prices shot up.

75 mbd. Matthew Simmons (2005) made essentially the same 

case for Saudi Arabia, the world’s largest oil exporter with a 

quarter of the world’s oil reserves, arguing that the country 

could not maintain its 2003 production rate of 9.5 mbd over 

the following fi ve to ten years. As it turns out, fi ve years later 

in 2008 Saudi oil production capacity was 11.5 mbd, and 

further capacity expansion is planned for 2009–11.5 Peak oil 

theory, irrespective of its merits, relates mainly to the long 

run and certainly cannot explain the run-up in oil prices over 

a few months. Moreover, oil prices then collapsed from their 

high of $147 a barrel in July 2008 to less than $40 a barrel in 

December of that year. Peak oil theory would imply that the 

sharp fall in oil prices in 2008 was due to the sudden discovery 

of new oil reserves. But, of course, there were no such surprise 

discoveries.6

5. Th e additional Saudi Arabian oil fi elds expected to be in production in 

2009 are: Khursaniyah (0.5 mbd), Shaybah (0.3 mbd), Khurais (1.2 mbd), 

and Nuayyim (0.1 mbd). Even factoring in possible delays in bringing these 

oil fi elds into production, total production capacity of Saudi Arabia in 2009 

will reach 11.5 to 12 mbd, up from 11.2 mbd in 2007. By 2011, the Manifa 

(0.9 mbd) off shore fi eld is also supposed to come online, which would broadly 

off set the declines in maturing fi elds, and total capacity would reach 12 to 

12.5 mbd. 

6. Hamilton (2009a) also agrees that the dramatic oil price collapse in late 

2008 is inconsistent with the scarcity rent hypothesis.

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 M1 M4 M7 M10 M1 M4 M7 M10 M1 M4 M7 M10 M1 M4 M7 M10 M1 M4 M7 M10 M1 M4 M7 M10 M1 M4 M7

 2003 2004 2005 2006 2007 2008 2009

US dollars/barrel

Figure 1 WTI oil prices, 2003–09

WTI = West Texas Intermediate

Source: US Department of Energy.
NUMBER PB09-19 AUGUST 2009

3

Fundamentals are certainly an important part of the 

story. Th e basic argument of the proponents of this view is 

that the price responsiveness of both the demand and supply 

of oil is very low,7

 so that small changes in demand require 

large changes in prices for markets to clear. As world GDP 

growth during 2007 and through the fi rst half of 2008 was 

very strong by historical standards, and supply was more or 

less fi xed by capacity constraints, oil prices would be expected 

to rise substantially. When the global economy started to slow 

down and then entered into recession in the second half of 

2008, demand fell off rapidly, and since supply declined more 

slowly as the Organization of Petroleum Exporting Countries (OPEC) began its production cuts in mid-2008,8

 prices 

dropped like a stone. Th ere is some general plausibility to this 

explanation, but at the same time there is a problem when it 

is applied to the 2008 experience. World real GDP growth in 

the fi rst half of 2008 was about the same as it was in 2007. 

With a low price elasticity of demand and income elasticity 

close to unity, as reported by the IMF (2009) and by Hamilton (2009a), one would expect the demand for oil to continue 

to expand. But in fact, world demand for crude oil actually 

fell to 86.3 mbd in the fi rst half of 2008 from 86.5 mbd in 

the second half of 2007. Furthermore, oil production rose to 

86.8 mbd from 85.8 mbd over that same period. Th is would 

suggest, if anything, that oil prices should have fallen in the 

fi rst six months of 2008. So market fundamentals alone, while 

having some validity, cannot fully explain the spectacular rise 

in oil prices from January to June.

Verleger (2008) has put forward a variant of the fundamentals hypothesis to explain the oil price increase of 2008. 

7. Averaging across a number of studies, the short-run price elasticity of demand is estimated to be less than –0.1 and the long-run price elasticity ranges 

between –0.2 and –0.3. See Hamilton (2009a). Given capacity constraints and 

the fact that supply is controlled to a large extent by governments in the major 

oil-producing countries, the price elasticity of supply is generally assumed to 

be close to zero.

8. OPEC production cuts were announced in March–May but became eff ective only after a lag of several months.

Essentially he argues that there was a shortage of light sweet 

crudes, which represent roughly a quarter of the world’s 

production of crude oil, and that heavier crudes were in plentiful supply, as evidenced by the level of inventories of the latter. 

It is true that the demand for lighter crudes is higher than for 

heavier crudes as there is limited refi nery capacity in the world 

to process heavy sour crudes, particularly as Verleger (2008) 

notes, to process jet fuel and diesel. Because they are easier 

to process, for a given level of demand, the price of lighter 

crudes is naturally higher than the price of heavier crudes. But 

then why did the price of heavy crudes rise in tandem with 

the price of lighter crudes, even when there was supposedly 

an excess supply of the former? For example, the discount on 

heavy crudes (like Arabian Heavy) relative to lighter sweet 

crudes (like West Texas Intermediate [WTI]) actually declined 

from 13 percent in 2006 to 8.5 percent in 2007 and increased 

only marginally to 9 percent in June 2008.9

 If there was excess 

demand for light crudes and excess supply of heavy crudes in 

2007–08, the discount should have increased, yet it actually 

fell as prices of both light and heavy crudes rose sharply in the 

fi rst six months of 2008.10 Verleger (2009), in his testimony at 

the Commodity Futures Trading Commission (CFTC) hearing in August, blames Saudi Arabian pricing policy, imitated 

by other OPEC members, for keeping the price of heavy crudes 

moving in line with prices of light crudes. However, for Saudi 

Arabia, and OPEC more generally, to maintain a higher price 

than the fundamentals for heavy crudes warranted, supplies 

of this type of oil would need to be kept off the market. In 

fact, total OPEC production rose steadily month by month 

from January through July 2008, and average daily production during these seven months was about 4 percent above 

the average daily production in 2007. Th e falling discount 

and rising production in the fi rst half of 2008 are diffi cult to 

reconcile with Verleger’s view that there was excess supply of 

heavy crudes in the market.11

Th ere is more of a consensus that the global recession 

played an important role in the subsequent collapse of oil prices. 

Between 1970 and 2007 there have been fi ve global recessions, 

defi ned as world economic growth falling to 21⁄2 percent a year 

or less. Th e largest recessions were the fi rst two (1974–75 and 

9. Th e average discount in 2003–05 was about 30 percent. At the end of June 

2008, Arabian Heavy was selling at $124 a barrel, while WTI was at $137 a 

barrel.

10. Th e rising demand for heavy crudes, despite the lack of refi neries, is 

because it is “blended” with the products from lighter crudes. 

11. Verleger (2008, 2009) argues that OPEC was storing the excess supply 

of heavy crudes, citing the example of Iran having to charter extra tankers in 

2008 to store the oil it could not move. But if there is a lack of demand, it 

would be more cost eff ective for producers to simply leave the oil under the 

ground, rather than pumping it out and then leasing extra tankers to store it. 

While market fundamentals obviously 

played a role in the general run-up in 

the oil prices from 2003 on, it is fair 

to conclude by looking at a variety of 

indic ators that spec ulation drove an oil 

price bubble in the first half of 2008.
NUMBER PB09-19 AUGUST 2009

4

1980–82), and oil prices did not immediately fall when the 

recessions began.12 In fact, oil prices remained quite fi rm one 

year into each of these recessions. By contrast, in the following 

three milder recessions (1991–93, 1998, and 2001) oil prices 

declined at the outset. Th e pattern of the last three recessions 

was repeated in the 2008 recession as oil prices plummeted 

as soon as it became evident that global growth was falling 

sharply. Th ere are several possible reasons why the pattern 

changed between the earlier and more recent recessions. First, 

the major oil producers switched from contract pricing in the 

1970s to largely spot selling in the 1990s, so price responsiveness was naturally slower in the earlier period as buyers 

were locked into contracts at higher prices, and there was a 

lag before these contracts expired. Second, OPEC had signifi -

cantly more market power in the 1970s and 1980s than it did 

from the 1990s on. So it was easier to prevent falls in prices 

as demand weakened in the earlier period. Finally, futures 

markets were relatively underdeveloped so there were limited, 

if any, opportunities to take speculative positions on future oil 

prices in the 1970s. Th is changed in the later period, so that as 

speculative long positions were unwound, oil prices fell more 

rapidly than they otherwise would have.

Speculation is a third possible explanation for the jump 

in oil prices. Th e argument runs as follows: While fundamentals were responsible for the rise in the equilibrium oil price, 

speculation on the future price of oil led to both overshooting 

of spot prices in the fi rst half of 2008 and undershooting in 

the second half of the year. Unfortunately, it is very diffi cult to 

measure speculation in any direct way. One obvious straightforward approach is to look at the data on the volume of oil 

futures; it turns out that these have grown spectacularly over 

the last few years (fi gure 2). In 2002 the average daily trading 

volume of oil futures (or paper barrels as they are known) was 

12. Both these recessions were associated with large prior hikes in oil prices, 

and even so prices stayed high.

four times the daily world demand for oil (physical barrels). 

By 2008, daily trading in paper barrels had reached 15 times 

the daily world production of oil (of around 85 mbd) and 

remained at about that level through the fi rst half of 2009.13

Th ese numbers are clear evidence of the enormous fi nancialization of the oil market that has taken place in only fi ve 

to six years, and some part of this surely refl ects speculative 

activities. A number of analysts also have used the volume of 

net open positions in futures markets because in principle it 

can yield information on movements in spot prices. Net open 

positions in oil futures more than doubled over 2003–07, and 

net long noncommercial positions at the New York Mercantile 

Exchange (NYMEX) reached new highs in early 2008.

Two problems, however, exist with using oil futures as an 

indicator of speculative activity. First, to isolate the speculative 

component in the net open positions one has to separate out 

commercial and noncommercial positions, since the former 

are presumably related to hedging rather than speculation.14

While separate data on commercial and noncommercial 

net open positions are reported, in practice the distinction 

between the two is more or less arbitrary.15 Second, if fi nancial fl ows into the futures market caused spot prices to rise, 

net long noncommercial positions would systematically lead 

spot prices. But IMF economists argue that many studies 

have found no evidence of systematic causality between oil 

fi nancial positions and spot prices in either direction (IMF 

2006, 2008a, 2008b). Th ese empirical fi ndings lead the IMF 

to reject speculation as a factor behind the oil price hike in 

2008, but this conclusion could simply be a consequence of 

the weakness of the indicator of speculative activity being used 

for the tests.16

Furthermore, unlike the adherents to the fundamentals 

viewpoint, the CFTC now considers that speculation has been 

an important factor in oil price movements and announced on 

July 7, 2009, that it would hold hearings in July and August 

to consider whether to impose speculative limits on futures 

13. In fact, the futures data are probably an underestimate since they do not 

include options or over-the-counter trades. Furthermore, it is important to 

note that major oil producers, like Saudi Arabia and the other OPEC countries, transact only in the spot market and not in the futures market. 

14. Th e CFTC estimates that about 20 percent of traders in the NYMEX 

are noncommercial, in the sense that they are fi nancial investors who are not 

users or producers of oil and are basically betting on the direction of prices. 

However, this is only an estimate, and the true proportion of noncommercial 

traders is thought to be considerably higher. See, for example, Masters (2008, 

2009).

15. Th e CFTC plans a major eff ort to improve the quality and transparency of 

futures data.

16. Since using net positions can obscure the true relationship between future 

positions and spot oil prices, an interesting empirical experiment would be to 

relate spot prices to long and short positions separately.

There will be upward pressure on oil prices 

in the next year or so as the world emerges 

from recession, demand for oil picks up 

again, and inventories fall back to their 

average or normal levels. Whether this will 

turn into a 2008-type bubble depends on 

the degree of speculation in the oil market.
NUMBER PB09-19 AUGUST 2009

5

contracts for energy products.17 Th is would bring oil in line 

with the policy of limits the CFTC places on speculative 

trading in agricultural products like wheat and corn. So far, 

futures exchanges themselves, principally NYMEX, have been 

allowed to set their own limits. In an op-ed in the Wall Street 

Journal on July 8, 2009, UK Prime Minister Gordon Brown 

and President Nicolas Sarkozy of France also expressed concern 

about “damaging speculation” and called for the International 

Organization of Securities Regulators to oversee the oil futures 

market and investigate the role that futures trading plays in oil 

price fl uctuations.

Th e IMF has rightly argued that if momentum trading—essentially buying commodities that have experienced 

high returns during some recent period and selling (or shorting) those that have low returns—was driving prices, one 

would have seen rising inventories of oil,18 which is a storable 

commodity. Since oil inventories have not risen, this would 

reject the possibility of momentum trading. But in the case 

of oil, one should not draw strong inferences because the data 

on oil inventories are notoriously poor, with many countries 

not reporting at all. In particular, most non-OECD countries, 

which make up a little less than half of world demand for 

crude oil and include very large consumers such as China, do 

not report data on oil inventories. Furthermore, oil invento17. Th is follows the call of the US Senate Permanent Subcommittee on Investigations in 2006 for greater regulation of the oil futures market.

18. Or production cuts, with producers keeping the oil under the ground.

ries do not include oil in tankers, commonly referred to as 

“oil at sea,” which distorts even the inventories data reported 

by the United States and other OECD countries. Th erefore, 

even though direct evidence is unavailable, to explain the oil 

price volatility in 2008 one cannot rule out speculative buying 

as a cause of the price surge in the fi rst two quarters of the 

year and the unwinding of positions as a determinant in the 

subsequent collapse of prices starting in the third quarter.

Another way to get a sense of speculative activity in the 

oil market is to compare movements in the real price of oil 

with the real price of gold. Th is relationship has been surprisingly close for a long time (fi gure 3). Gold is well known to 

be a highly speculative commodity, driven by factors other 

than derived demand (industrial or consumer). One could 

reasonably argue that the relationship between real gold prices 

and real oil prices, which continued in 2008, is also evidence 

of speculative behavior in the oil market. In fact, oil prices 

rose at a much faster rate than gold prices from about 2002 

onwards, with the gap between them in 2008 becoming the 

largest observed over the period 1970–2008.19 In the fi rst half 

of 2008, while real oil prices rose by over 50 percent, real gold 

prices increased by only about 13 percent. All in all, since 

2002, oil seems to have been an asset that was a better bet 

than even gold for investors. Starting in July 2008, the decline 

in gold prices was correspondingly less (falling by 19 percent) 

19. Since fi gure 3 uses yearly average data, the 2008 average prices of both oil 

and gold show up as signifi cantly higher than their respective 2007 average 

values.

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8

6

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0

2002 2007 2008 2009–to date

ratio of volume of oil futures to world oil demand

Figure 2 Average daily trading volume of oil futures to world oil demand

Source: Morgan Stanley.

4.5

12.7

14.7

15.3
NUMBER PB09-19 AUGUST 2009

6

than in oil prices (which fell by about 70 percent), perhaps 

partly because they had risen far less to start with and partly 

because gold became a safe haven for investors in an environment of extreme banking and fi nancial system uncertainty.

LONG-TERM EQUILIBRIUM OIL PRICE

Ideally, if one knew what the long-term equilibrium price of 

oil was, one could have a baseline against which to compare 

the actual level of spot prices. If spot prices were signifi cantly 

above the equilibrium price, which is determined by fundamentals, this would suggest a “bubble.” Th is then leads to the 

second question: Did prices overshoot in the fi rst half of 2008 

and undershoot thereafter?

Absent a formal model to determine the equilibrium 

price of oil, one has to rely basically on the judgment of those 

who watch the market closely or are active in it. For example, 

Sheikh Khalifa bin Zayed Al Nahyan, president of the United 

Arab Emirates, and Saudi Arabian Minister of Petroleum Ali 

Al-Naimi, both said recently that $70 to $75 a barrel represents a “fair” price for both oil consumers and producers. 

Other OPEC members share this view, and $70to $75 seems 

to have now been accepted in the market as a kind of benchmark price of a barrel of oil. It is generally believed that a price 

much higher than this could have adverse eff ects on the world 

economy, and a price much lower would be a disincentive for 

economizing on oil consumption and developing alternative 

energy sources. 

One possible indicator of an equilibrium price of oil is the 

market valuation of major oil companies.20 Th e market’s valuation of oil companies should respond mainly to changes in longterm oil price expectations. Since proven oil reserves constitute 

a large part of the assets of these oil companies, an increase in 

long-term oil prices would lead to higher investments and higher 

future profi ts, which would, therefore, be refl ected in their equity 

price. Since valuations are based on long-term price expectations, 

they will be less volatile than spot prices. Short-term deviations 

between valuations and spot prices would be temporary, and a 

bubble would be related to the duration and amplitude of the 

deviation. Over the long run, however, there should be a close 

relationship between spot oil prices and market valuations.

Th e data support this hypothesis to a considerable extent. 

As shown in fi gure 4, over the past two decades the spot price 

20. Aasim Husain and I fi rst used this indicator in 2008 as a proxy for the 

long-term price of oil in order to disentangle the temporary and permanent 

components in oil prices. Th is is basically the same approach taken by Verleger 

(2005) in using share values of BP Prudhoe Bay Royalty Trust to back out 

long-term price expectations.

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1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

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Gold price/US CPI (left axis)

WTI oil price/US CPI (right axis)

US dollars/ounce

Figure 3 Real oil and gold prices, 1970–2008

WTI = West Texas Intermediate

CPI = consumer price index

Source: International Monetary Fund.

US dollars/barrel
NUMBER PB09-19 AUGUST 2009

7

of WTI crude has tended to move in tandem with the price 

of the S&P 500 Integrated Oil and Gas Index.21 Indeed, oil 

companies’ valuations have exhibited signifi cantly lower shortterm cyclical volatility than crude oil prices, and the latter have 

tended to return to levels consistent with corporate valuations 

over the medium term.

Past deviations between oil prices and oil company valuations have been associated with temporary shocks to oil 

demand or supply. During the First Gulf War in 1991, for 

example, crude oil prices surged while oil equity prices were 

stable. Similarly, oil prices fell substantially in the aftermath of 

the emerging-market fi nancial crisis and again following 9/11, 

while oil company valuations remained broadly stable during 

both episodes. Again in the second half of 2008, oil prices fell 

by nearly 70 percent while corporate valuations declined by 

much less (about 20 percent), generally in line with the decline 

in stock markets. Th is pattern is consistent with the idea that 

corporate valuations in the oil sector do not react to short-term 

oil price developments and are instead determined mainly by 

long-term oil price expectations.

21. Th e index comprises stocks of the following companies (and weights): 

ExxonMobil (0.47), Chevron (0.21), ConocoPhillips (0.15), Occidental 

(0.08), Marathon (0.04), Hess (0.04), and Murphy (0.03). Th e correlation 

with WTI also holds with equity prices of individual companies such as 

ExxonMobil and Chevron.

By implication, the steady rise in oil prices during 

2003–07, because it was accompanied by a similar increase in 

oil-company valuations, appears to be “permanent.” On the 

other hand, the steep hike in oil prices in the fi rst half of 2008, 

which resulted in a large deviation between crude prices and 

oil-company equities, appears “temporary,” or a bubble. Th e 

long-term, or permanent, component of crude oil prices based 

on corporate valuations was at that time $80 to $90 a barrel, 

but spot prices were around $50 higher.

Although the absolute magnitude of the estimated temporary component of oil prices in early 2008 became very large, 

it was still substantially smaller than some of the peak deviations of the past when scaled by the prevailing long-term oil 

price. In 1990, for example, oil prices shot up to about twice 

their long-term level, while in 1998 they fell to about half the 

long-term trend. In December 2008 the estimated temporary 

component (actual spot price) was about $20 a barrel below 

the permanent component (corporate valuations price).

It should be noted that temporary oil price swings, or 

bubbles, can vary in persistence. Th e swing following the emerging-market crisis took two years to reach its peak and another 

year to unwind, but the spike associated with the First Gulf War 

was very short lived.22 Th e 2008 oil price surge was also reversed 

22. As Maugeri (2006) notes, when the United States attacked Iraq on JanuUS dollars/barrel

Figure 4 Oil and oil-company stock prices, 1989–2008

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 WTI (left axis)

 S&P 500 Integrated Oil and Gas Index 

(February 1994 = 100)

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

WTI = West Texas Intermediate

Source: International Monetary Fund.

index
NUMBER PB09-19 AUGUST 2009

8

quite quickly as the price fell sharply during the last few months 

of the year to well below the equilibrium price, indicating that 

it did undershoot substantially and would start to rise toward 

the equilibrium price. Furthermore, unlike previous episodes, 

the deviation in 2008 between the spot and equilibrium prices 

was preceded by a large upward revision in long-term oil price 

expectations over the previous fi ve years.

GOING FORWARD

While market fundamentals obviously played a role in the general run-up in the oil prices from 2003 on, it is fair to conclude by 

looking at a variety of indicators that speculation drove an oil 

price bubble in the fi rst half of 2008. Absent speculative activities, the oil price would probably have been in the $80 to $90 a 

barrel range.23 What, then, does the 2008 phenomenon imply 

for the future? If the market valuations indicator returns to 

trend, then a price of $80 to $90 a barrel is clearly in the cards. 

In fact, spot prices are already around $70 a barrel and appear 

to be climbing back to their 2008 equilibrium level of $80 to 

$90 a barrel, so that day may be fast approaching. Indeed, some 

forecasters, such as Goldman Sachs, are already revising their 

projections signifi cantly upward for 2010–11, generally in the 

$90 to $100 a barrel range, which would be somewhat above 

the equilibrium price as defi ned here. 

Th e key question is whether another oil price bubble is 

likely in the future. Naturally, one cannot predict bubbles, 

as by defi nition we don’t know what causes them in the fi rst 

place. But it is clear that there will be upward pressure on oil 

prices in the next year or so as the world emerges from recession, demand for oil picks up again, and inventories fall back 

to their average or normal levels. Whether this will turn into 

a 2008-type bubble depends on the degree of speculation in 

ary 17, 1991, as part of Operation Desert Storm, crude oil prices fell from 

$30 a barrel to $20 a barrel the very same day. Th is was largely due to the 

US announcement that day that it would release 35 million barrels from its 

Strategic Petroleum Reserves. Furthermore, other OPEC countries committed 

to making up for the loss of oil production from Iraq and Kuwait and did so 

during the rest of 1991.

23. Th is is the price most major oil producers had expected for 2008.

the oil market. If, as argued in this policy brief, speculation 

played a signifi cant role in the 2008 bubble, then something 

will need to be done to control it to prevent the emergence of 

another bubble in the future. Th e policies being considered by 

the CFTC (2009) to put aggregate position limits on futures 

contracts and to increase the transparency of futures markets 

are moves in the right direction. 

A longer-run danger for the world economy, independent 

of the speculation argument, is that oil capacity expansion 

has slowed in 2009,24 and both national and multinational 

oil companies are postponing plans to develop new fi elds and 

expand existing ones. Even though there is currently a serious 

push for greater fuel economy and development of alternative 

sources of energy, it is unlikely that these new technologies 

will make a signifi cant dent in the demand for oil over the 

next few years. Th e International Energy Agency, for example, 

based on IMF projections of world growth, forecasts world 

demand for oil to rise by about 0.6 percent a year from 2010 

on, reaching 89 mbd by 2014. If supply does not keep up 

and provide the additional 3 mbd needed by 2014, a serious 

imbalance between future demand and supply in the world oil 

market would emerge. A major joint eff ort on the part of both 

producers and consumers to correct this potential imbalance, 

possibly along the lines proposed by Prime Minister Brown 

and President Sarkozy, involving both capacity expansion and 

conservation, will be needed over the next few years. Absent 

such an agreement, and if there is no brake to speculation, a 

repeat of 2008 could easily occur with spot oil prices soaring above their long-term equilibrium level. Whether this is 

a high-probability scenario or only a “tail” risk is a matter of 

judgment, but the signs are there. Unless appropriate policy 

actions are taken to bring the oil market into long-term 

balance, and to limit speculation, it may well be that the 

$147 a barrel hit in 2008 was not just a once-in-a-lifetime 

event but rather a harbinger of things to come.

24. For example, OPEC has recently reported that upstream investments 

planned by member countries over the period 2009–13 have fallen from 

$165 billion to $110 billion–$120 billion, as these countries revised their oil 

demand forecasts downwards for the medium and long run. See OPEC (2009).

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Hamilton, James. 2009b. Understanding Crude Oil Prices. Energy 

Journal 30, no. 2: 179–206.

IMF (International Monetary Fund). 2006. World Economic Outlook 

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IMF (International Monetary Fund). 2008a. World Economic Outlook 

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9

Th e views expressed in this publication are those of the author. Th is publication is part of the overall program 

of the Institute, as endorsed by its Board of Directors, but does not necessarily refl ect the views of individual 

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