"For two days this week, oil was looking like a typical bubble market. The price slid more than $10 a barrel in two days. Had supply and demand changed that much? Was this the beginning of the end of high oil prices?No, no, no. In the face of potential supply disruptions, the price of short-term futures contracts on oil may bounce around quite a bit. If the market estimates that there is a 10% chance Iran will block the Strait of Hormuz in a showdown with the West, causing oil to shoot up to $400 per barrel, the price will be around $25 per barrel higher than it otherwise would be. By contrast, if there is only an estimated 5% chance, the impact is half as much. Since such estimates are subjective and dependent on the complicated psychology of the Iranian and Israeli regimes, we can expect them to move around significantly in response to seemingly trivial events, like the short-term aftermath of a missile launch. This will result in price swings that have nothing to do with a "bubble."
Then on Thursday, the oil price bounced up at the end of the trading session. It’s hard to see what news might have triggered that. The day’s major developments – the firing of missiles by Iran and an e-mail from Nigerian insurgents calling off their self-declared ceasefire – were known at the beginning of the day. Brazilian oil workers were planning a strike, but the International Energy Agency lowered consumption forecasts. Go figure.
That led some analysts to say that the oil market is indeed a bubble."
In any case, declaring that the oil market is a "bubble" is highly misleading. Even if investors are overestimating the risk of short-term supply shocks, causing the price of short-term futures contracts to be inflated by $10 to $15, the bulk of the increase in oil prices is not a result of any such speculation. In the past few months, markets have cleared at very high oil prices. If these oil prices over the past year had been the result of "speculation," we would have seen massive hoarding of oil by private investors. It's a conventional story of supply and demand: if the price of oil was really inflated beyond what the market was able to support, then supply must have exceeded demand and the excess must have been stored somewhere. This has not happened. At most, therefore, any "speculation" has been limited to relatively small, short-term changes in the prices of oil futures, and this may be a perfectly rational response to the changing probability of geopolitical supply shocks. Hardly a "bubble"!