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George Soros explains the oil bubble

Jun. 03, 2008 | Anyone hoping that George Soros would make the case that the high price of oil is predominantly due to speculation and market manipulation will be disappointed by his testimony before Congress on Tuesday. The truth is more complicated.

Soros listed four factors as playing a role

• "First, the increasing cost of discovering and developing new reserves, and the accelerating depletion of existing oilfields as they age. This goes under the rather misleading name of peak oil."

• "Second, there is what may be described as a backwards-sloping supply curve. As the price of oil rises, oil-producing countries have less incentive to convert their oil reserves underground, which are expected to appreciate in value, into dollar reserves above ground, which are losing their value."

• "Third, the countries with the fastest-growing demand, notably the major oil producers, China and the other Asian exporters, keep domestic energy prices artificially low by providing subsidies, therefore rising prices don't reduce demand as they would under normal conditions."

• "Fourth, both trend-following speculation and institutional commodity-index-buying reinforce the output pressure on prices. Commodities have become an asset class for institutional investors and they are increasing allocations to that asset class by following an index-buying strategy. Recently, spot prices have risen far above the marginal cost of production and far out forward contracts have risen much faster than stock spot prices."

So, do we have a speculation-fueled bubble?

The answer is that the bubble is superimposed on an upward trend in oil prices that has a strong foundation in reality ... The first three factors I mentioned are real and would persist even if speculation and commodity-index-buying were eliminated.

The really hard part of this multi-variable equation is deciding how much weight to assign to each factor. Is the rising cost of developing new oilfields more or less important than the flood of pension fund money pouring into commodity indexes? Perhaps the answer will emerge in later testimony during Tuesday's Senate hearing, but I doubt it. The best that can be said is precisely what Soros outlined: Real-world circumstances have created a mismatch between supply and demand, which sets the stage for a speculative frenzy.

A side note: A number of readers have argued that world demand for oil hasn't grown fast enough to justify the remarkable growth in prices, so there must be something underhanded going on. But I think that argument doesn't appreciate how all you need is just a little bit more demand than supply to get prices moving up quickly. As soon as there are more bidders than suppliers, they all start competing against each other. If supply stagnates, as it has for the last couple of years, prices can easily go through the roof, as speculators jump in to take advantage. So yes, there is speculation, but the fundamental driver at work is still growing demand.

-- Andrew Leonard