Wednesday, May 14, 2008

Oil price and speculation

Reading this report from Bloomberg, I was wondering about another possible explanation for the puzzle raised many times by Paul Krugman in his NY Times column: Krugman claims if speculation is the true culprit, you will have to see a large inventory buildup of oil. However, there is no evidence for the inventory accumulation.

The new possibility is that if oil suppliers realize or fear that the current fast run-up of oil price is unlikely to last, they will not increase production capacity. Therefore on one hand, commodity futures and other financial products (such as ETFs) keep bidding up oil price higher and higher, while on the other hand there is not much increase of supply (then no inventory buildup).

Just like farmers decide not to plant more corns because they expect corn price will fall next year. Oil producers are likely to do the same thing: They don't want to get burned. Seems like rational expectations theory in application.