James Hamilton writes,

The “fundamentals” price of oil depends on a number of factors that cannot be perfectly foreseen. Among these are (1) will the world enter a deep and prolonged recession in 2007, and (2) will global oil production in 2007 be higher than it was in 2006? Today, we know that the answer to both questions is no, and conditional on knowing that answer, we can see that $60/barrel was too low a price. But a year ago, no one knew those answers.

…Did the movement along the demand curve that resulted from the increased price show up as an increase in inventories? The correct answer is, no, it was offset by a shift in the demand curve for newly industrialized countries and the oil producing countries. For example, China may have consumed a half million more barrels of oil per day in 2007 compared with 2006.

Hamilton, Krugman, Cowen and I seem to agree that speculators took the wrong view of oil markets early in 2007. Implicitly, then, we agree that oil prices today depend on expectations for the future. However, Hamilton talks more about the near-term future–the outlook for recession and near-term production. Krugman talks longer term (Saudi exhaustion, Russian oil not appearing), and I talk infinite horizon.

We agree that trying to reduce oil demand by getting rid of speculators is foolish. Knowing what we know now, we seem to think that the price of oil is close to where it belongs, although events could change that.

Krugman and Hamilton want to account for the excess oil that should appear as the price shoots up from $60 to $130+ per barrel. Krugman says that the fact that it does not show up in above-ground inventories is a sign that speculation is not at work. Cowen and I say that the excess oil might be underground, although I have to do a lot of hand-waving and fall back on the fudge factor of “convenience yield,” given that futures prices are not far above spot prices.

Hamilton says, eloquently, that “China already burned” the excess oil. That probably ought to go down as the definitive assessment.

We should not forget Mark Thoma’s point that other commodity prices also have risen. Maybe China burned some of those too, but Thoma’s question still troubles me.

Suppose you asked me to assign probability weights to each of three explanations for commodity price increases over the past year:

(a) changes in fundamentals;
(b) monetary shock;
(c) wave of speculation.

At the moment, my weights add up to less than one, and yet I cannot think of other explanations.

My problem with (a) is that, given my infinite-horizon perspective, I don’t see the news in oil markets over the past year as sufficiently dramatic. On top of that, one has to come up with plausible “big news” in various other commodity markets.

My problem with (b) is that I don’t think we’ve undergone a regime change in terms of inflation tolerance. Also, I tend to disdain the whole Fed-watching industry. My general outlook leads me to discount the notion of monetary shocks. The fact that I even brought it up is a huge concession.

My problem with (c) is that it would put me in the position of betting against the market when other economists are not doing so. (I was ok taking a position in foreign securities a few years ago, because I found economists’ arguments that the dollar was overvalued to be persuasive.) Krugman thinks that (c) impossible, unless the futures-spot differential leads to observable hoarding. As a purely theoretical matter, I believe that a general wave of speculation could drive up commodity prices, and that the excess supplies that result could be stored in many ways, at different stages of processing. As an empirical matter, I think it highly unlikely that (c) will prove to be the answer.