The Oil Bubble Peaks

The Oil Bubble Peaks

On this day in economic and business history...

The price of a barrel of oil reached an all-time trading high of $147.27 on July 11, 2008. Prices had been on the rise for several years, a trend blamed on everything from inflation fears to Iranian saber-rattling. The prevailing wisdom was that oil-thirsty economies were simply driving the price higher before new sources could be brought online, but a growing chorus of dissent during this time pointed to a surging derivatives market as evidence of an oil bubble. Evident problems in the global economy, which was two months away from a wave of massive financial-industry failures, had done nothing to stop the rise of oil -- but that would end after July 11.

Fears of peak oil couldn't easily explain the oil price spike. Nearly 8 million barrels of new daily production had been brought online between the turn of the century and the peak of the bubble, but consumption demands had risen by roughly the same amount during that period. Peak oil also couldn't account for the sudden plunge in oil prices that took place after July 11, as there was no sudden flood of new supply. The recession certainly played a part in oil's plunge, but how easily could a rising global economy explain the tripling of oil prices in four years? After all, the strong economy of the 1990s experienced steady oil price declines.

Speculation presents a more compelling explanation for the stunning rise and fall of oil prices. Former IMF director Mohsin S. Khan, writing for the Peterson Institute for International Economics a year after the peak, lays out this case:

In 2002, the average daily trading volume of oil futures (or paper barrels as they are known) was four times the daily world demand for oil (physical barrels). By 2008, daily trading in paper barrels had reached 15 times the daily world production of oil (of around 85 million barrels per day) and remained at about that level through the first half of 2009. These numbers are clear evidence of the enormous financialization of the oil market that has taken place in only five to six years, and some part of this surely reflects speculative activities.

Another indicator of speculative activity, according to Khan's paper, is the divergence of oil and gold prices during the bubble years. The gold price spike after the turn of the century is well-known, but oil prices actually exceeded this increase, and in the first half of 2008 oil prices shot up by 50%, while gold gained only 13%. Oil and gas company stocks also diverged from oil prices near the peak of the bubble: Oil prices doubled in the year leading up to the peak, but both ExxonMobil and Chevron were flat. In the year following the peak, oil prices fell by 60%, but stocks of the two oil supermajors lost roughly 25% apiece.

An incendiary article by Rolling Stone bomb-thrower Matt Taibbi later pinned much of the blame for the speculative spike on Goldman Sachs , which was depicted in typical Taibbi fashion as a devious Wall Street puppet master:

So what caused the huge spike in oil prices? Take a wild guess. Obviously Goldman had help -- there were other players in the physical commodities market -- but the root cause had almost everything to do with the behavior of a few powerful actors determined to turn the once-solid market into a speculative casino. Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures -- agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock. Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300%. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.

The ongoing anger against commodity speculation in general, and oil speculation in particular, gave rise to the Obama administration's drive to limit such overinvestment in 2012. At that time, The New York Times reported that speculators were responsible for as much as 40% of the present price of oil. However, little has been done to reform the way oil is traded, and considering that roughly 80% of all oil contracts are still bought and sold by speculators, it seems that little political will exists to reform the process.

We may not be headed back to $147 oil, but it doesn't look like oil prices will be dropping anytime soon, either. Find out how you can take advantage of these high prices with The Motley Fool's "3 Stocks for $100 Oil." For FREE access to this special report, simply click here now.

The first highway project
The Federal Aid Road Act, America's first highway-construction legislation, was signed into law by President Woodrow Wilson on July 11, 1916. The Act appropriated roughly $75 million in federal funds for highway-building, and much of it would be used to improve "post" roads, the roads used by mail carriers. This built on a failed earlier post-road improvement project and would lead to the establishment of state highway agencies staffed with dedicated engineers to adequately disburse the funds. Unfortunately, America's entry into World War I interrupted the development of the nation's highways, and by the time the troops returned home, very little had been paved.

The Act's inadequacy was laid bare by a disastrous transcontinental military convoy trip made in 1919. The trip, attended by future President Dwight Eisenhower, helped spur the Federal Highway Act of 1921. This early effort would lay the groundwork for Eisenhower's landmark Federal Aid Highway Act of 1956, which finally developed the vast national road infrastructure that has turned America into a nation of suburbs and shopping malls.

Nasdaq rising
The Nasdaq continued its climb up Dot-Com Hill on July 11, 1997, and on that day the tech-heavy index finished above 1,500 points for the first time. It had been only two years since the Nasdaq had broken the four-digit barrier for the first time, and it had taken roughly four years to double from 750 points. In the same four years, the Dow Jones Industrial Average had actually outperformed the Nasdaq, rising from about 3,500 points to nearly 8,000 -- a milestone the Nasdaq upstaged with its July 11 surge.

However, the next three years would undeniably belong to the Nasdaq. By the time it hit 5,000 points in early 2000, its 233% growth from mid-1997 had left the Dow in the dust. The Dow's ultimate dot-com peak, at just more than 11,700 points, was only good enough for a 48% gain over its close on the Nasdaq's first 1,500-point day.

The article The Oil Bubble Peaks originally appeared on

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more insight into markets, history, and technology.The Motley Fool recommends Chevron and Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.