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June 10, 2008

Oil Bubble?

Yes… but.

It's an important question since the answer affects a huge swath of business, personal, and government decisions – not to mention political campaigns. Is the historically high price of oil in dollars a temporary aberration, the creation of evil market manipulators, a frothy bubble that'll look absurd after it collapses? Or are we at the very beginning of a repricing of energy and other commodities caused by developing nations developing ("developing" used to be just a euphemism like "needs improving" on a report card) and the formerly destitute becoming consumers faster than resources can be found for them to consume?


Let's start with recent history and remember that supply and demand are never in a static balance. They affect each other and are both affected by myriad other factors. There is always change. Sometimes muted, sometime violent. This change is fractal. It is non-linear; in the short-term it may appear to follow the smooth charts of economists or other forecasters. In the long run both the direction and rate of change are unknowable and unpredictable like any other fractal phenomenon.

OK. We had a period of relative stability in energy prices. Think of the prices as a pendulum swinging back and forth: movement in one direction was about equal to movement in the other; the average was reasonably constant.

Now somebody tilts the structure which contains the pendulum – the tilting force in this case was new demand coming online faster than new supply but it didn't have to be something so significant or straightforward. The "average" has now shifted; the pendulum swings through a wider arc. Will it stop when it gets to the new "equilibrium" point? Of course not, it'll overshoot; then it'll overshoot in the other direction. Volatility is a symptom of rapid change.

The wildly swinging pendulum, however, moves the structure from which the weight hangs. It too careens in one direction and then the other. The movements of the structure, in turn, affect the pendulum. Now add in a bunch of people who are trying to stabilize (or upset) either the structure or the pendulum itself. In physics this is called the n-body problem. To quote from wikipedia:

"For n ≥ 3 very little is known about the n-body problem…

"The three-body problem is much more complicated; its solution can be chaotic. A major study of the Earth-Moon-Sun system was undertaken by Charles-Eugène Delaunay, who published two volumes on the topic, each of 900 pages in length, in 1860 and 1867. Among many other accomplishments, the work already hints at chaos, and clearly demonstrates the problem of so-called "small denominators" in perturbation theory."

Net: You can't believe anyone who says he or she knows where energy prices are going to be tomorrow let alone next week or next year. They could even crash below historic lows in the case of a worldwide recession, an epidemic, or certain wars – or technical breakthroughs. They could move much higher than they are now.

I'm sure people are making money in oil speculation. I'm just as sure some speculators are losing their shirts – just as I'm sure there are winners and losers in Las Vegas. I'm sure the chaos creates cover for illegal and immoral acts. My guess is that the speculation sometimes dampens the price swings and sometimes exacerbates them and can lead to bubbles – certainly – but can't create long term trends.

I'm also reasonably sure – barring a number of both foreseeable and unforeseeable catastrophes (black swans) – that demand for energy is currently growing faster than supply if price were a constant (which, of course, it isn't). I'm not at all sure that high-priced oil won't lead to a breakthrough in either supply or demand technology – or both – that'll lead to a decline in the price of energy if not oil itself. Through human history, energy costs have gone down and not up.

Is all this unknowability a cause for inaction? Of course not. Times of rapid change are times of great opportunity and great danger. We have to guess at short term trends; we have to duck when the pendulum swings towards us. We are sentient bodies in this n-body problem. The future is being built on the rubble of the past but the past is not necessarily prologue to the future.

The only certainty is change and change is a fractal.


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