The 2008 Oil Price "Bubble"

by Mohsin S. Khan, Peterson Institute for International Economics

August 2009

Mohsin S. KhanAs 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 question is whether the world is in for another oil price spike in the near term similar to that witnessed in early 2008. World oil prices skyrocketed from about $90 a barrel in January 2008 to cross the $140 a barrel mark in June, finally hitting a record high of $147 a barrel on July 11, 2008 before collapsing to less than $40 a barrel in December. Was the oil price increase of over 50 percent in the first six months of 2008 a bubble? If it was a bubble and oil prices overshot their long-term equilibrium level in the first half of 2008, did they undershoot when the bubble burst in the second half of the year?

Khan looks at a variety of indicators and explanations and concludes that speculation in the oil market created an oil price bubble in the first half of 2008. Absent speculative activities, the oil price would probably have been in the $80 to $90 a barrel range. What, then, does the 2008 phenomenon imply for the future? If, as Khan argues, speculation played a significant role in the 2008 bubble, then policies—such as those being considered by the US Commodity Futures Trading Commission—to limit aggregate futures positions will need to be implemented soon to prevent another bubble from emerging.

Another long-run danger for the world economy is that oil capacity expansion has slowed in 2009 but world oil demand is predicted to rise to 89 million barrels a day by 2014. If supply does not keep up and provide the additional barrels needed, a serious imbalance between future demand and supply in the world oil market would emerge. A major joint effort on the part of both producers and consumers to correct this potential imbalance, possibly along the lines recently proposed by UK Prime Minister Gordon Brown and French President Nicolas Sarkozy, involving both capacity expansion and conservation, will be needed over the next few years. Absent such an agreement, and if speculation is not controlled, oil prices could rise much higher than their long-term equilibrium level.

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