By Justin Lahart
The Wall Street Journal
May 26, 2008
After being buffeted by the dot-com, housing and credit bubbles -- not to mention the Chinese stock-market bubble -- there is a readiness by people on Wall Street and elsewhere to ascribe the term "bubble" to all sorts of things. But when it comes to commodities like crude oil and corn, that may be off the mark.
A bubble, says "The New Palgrave Dictionary of Economics," "refers to asset prices that exceed an asset's fundamental value because current owners believe they can resell the asset at an even higher price."
But figuring out whether a commodity exceeds its fundamental value is difficult: Because there is no income stream, there is no equivalent to the price-to-earnings ratios that people use to value stocks.
Prices, to be sure, are soaring -- crude oil fetched $132.19 a barrel in New York on Friday, up 103% from $64.97 a year earlier. Yet crude has posted similarly massive increases a number of times in the past three decades. Most notably, in the spring of 1980, as gasoline lines lengthened, the price of crude oil was 150% above the year-before level.
That price spike was caused mainly by a production cutback by the Organization of Petroleum Exporting Countries -- coupled with the fact that consumers had few alternatives. But over time, the high prices spurred conservation by consumers and increased exploration and production in non-OPEC countries. Oil prices collapsed.
The episode is a textbook example of the huge price swings that can occur when supply and demand are relatively inelastic in the short run, but not in the long run, says Harvard economist Greg Mankiw, who cited it in an economics textbook he wrote.
Mr. Mankiw, like many others, thinks that increasing demand from China and other developing countries is behind much of the rise in oil prices.
High prices are sparking some conservation efforts -- on his blog, he has noted that some people are switching to mass transit, buying bicycles and, in the case of one Tennessee farmer, switching from tractor to mule.
"But it takes years for people to fully adapt," Mr. Mankiw says.
In the meantime, the response of oil producers to rising oil prices seems more sluggish than ever, leading worries that crude production has peaked.
The Paris-based International Energy Agency, which is conducting a comprehensive study of the world's top oil fields, is preparing to revise its oil-supply forecast downward.
For other commodities, supply and demand change more quickly in response to higher prices.
Some of the biggest recent price drops have occurred in commodities like wheat and cotton, which are renewable and have potential substitutes, says Howard Simons, a strategist at Chicago-based Bianco Research.
By contrast, oil and natural gas aren't renewable, aren't recyclable and don't have easy substitutes. Corn is renewable, but because much of the corn crop is getting diverted toward making ethanol, its prices are rising as well.
So it is far from clear that the first part of the bubble definition -- prices in excess of their fundamental value -- is in place. But the second part -- that people are buying in anticipation of selling at a higher price -- certainly is.
Speculation has long played a role in the commodities markets, but in recent years it has become much larger.
The traditional role of the commodity-futures markets was to allow players such as farmers and oil refiners to hedge against unexpected price swings. Now, more institutional investors are wading into commodity markets to invest, rather than hedge.
In February, the board of the California Public Employees' Retirement System, or Calpers, the largest pension fund in the U.S., authorized putting as much as 3% of its $240 billion portfolio in commodities. Hedge-fund manager Michael Masters told a U.S. Senate committee last week that institutional investors "are one of, if not the primary, factors affecting commodities prices today."
But Bianco Research's Mr. Simons say that because the final buyers of commodities are consumers rather than investors, the role of speculation is limited. "Commodities, unlike financial assets, cannot take on hope values very much," he says. "At some point, the price gets to the point where the buyer walks away."
In commodity markets, what is traded aren't physical commodities but contracts that are essentially bets on where prices will go, Harvard's Mr. Mankiw says. The final effect of the bets is limited unless they encourage speculation in the commodity itself -- encouraging, say, a coffee broker to warehouse coffee in hopes of getting a higher price later.
And that is what is happening, according to Mr. Mankiw's Harvard colleague Jeffrey Frankel, who says such speculative behavior is due to the sharp reduction in interest rates by the U.S. Federal Reserve. Low rates encourage commodity stockpiling, he says, by making it less attractive to sell commodities and put the proceeds into bonds and other debt instruments.
Critics of Mr. Frankel's theory say the expected rise in commodity inventories hasn't shown up. Mr. Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground. That could be one reason why the Saudi king rebuffed U.S. President George W. Bush's request for increased oil production earlier this month.
That would be a reckless game to play, because it could lead to the types of shifts that caused energy prices to drop precipitously in the 1980s, inflicting heavy damage on the Saudi and other OPEC economies. Indeed, the combination of a change in consumer behavior and an economic slowdown that is showing signs of spreading beyond the U.S. may already augur just the kind of sharp drop in prices that occurred back then. But if that happens, it won't be because oil prices were in a bubble; it will just be because that is the way commodity markets work.
