Unexpectedly Intriguing!
July 14, 2008

Writing at PhysOrg, Lisa Zyga reports on the work of researchers that suggests that today's spike in oil prices is largely based upon the actions of speculators rather than changes in currency valuations or fundamental issues of supply and demand. Here's the lede:

Since 2003, worldwide oil prices have quadrupled. According to a new study, the price of oil is rising at a faster-than-exponential rate, and cannot be sustained. In other words, we’re in the midst of an oil bubble, say researchers Didier Sornette and Ryan Woodard of ETH Zurich in Switzerland and Wei-Xing Zhou of the East China University of Science and Technology in Shanghai, China.

By analyzing oil prices over the past four years, the researchers have demonstrated more support for the hypothesis that the recent oil price run-up has less to do with supply-demand interplay and more to do with speculation.

Here's how the team of researchers came to this conclusion:

In their analysis, the team gathered data on oil prices since 2005 in US dollars, euros, and other major currencies (to confirm that the results are not a consequence of the weakening of the US dollar). They also examined worldwide oil supply and demand data, specifically investigating the extent of increased demand from emerging markets such as China and India.

Then, the researchers analyzed this data using a method that Sornette’s group started to develop in 1996 that identifies bubbles as "transient superexponential regimes" – basically, areas of rapid growth that occur due to a source of positive feedback within the system. The scientists looked at the data in the context of three different models, and all three models revealed the existence of a “log-periodic power law,” in mathematical terms – in other words, a bubble. In economic terms, the researchers explain, a bubble refers to a situation in which expectations of future price increases cause prices to temporarily rise without justification from fundamental valuation.

Brown University: Matched Tuning Forks Sympathetic Vibration Demonstration http://www.physics.brown.edu/physics/demopages/Demo/waves/demo/3b7010.htm As we would interpret it, a "transient superexponential regime" is really a kind of resonance phenomenon. Like the sound produced by a tuning fork being struck at just the right frequency, a bubble results when the individual components of a system (in this case, the world's oil markets), become super-excited or amplified as the result of simultaneous feedback (keeping with the sound metaphor, let's call this "market buzz") generated by other participants in the market (traders, investors), which then reinforces the signal being sent by the original sources, and even amplifies it as new participants enter the resonating market.

In this super-excited state, even small perturbations can produce very large effects (such as significant spikes in prices) as the system accumulates increasing amounts of energy (additional money from market participants). The reason this occurs is because when objects (market participants) are in resonance with one another, they exchange energy (information) with each other very efficiently but only interact weakly with extraneous sources of energy in their environment (say, information related to underlying supply-and-demand fundamentals that normally govern the market). As a result, in this example, amplified prices detach from their established relationship with those underlying market fundamentals, leaving us with what we call a bubble.

Eventually, extraneous energy (information) successfully enters into the system (the bubble market) and the state of resonance ends (the market crashes).

For us, what we find interesting is that no-one would seem to have a good operational definition of just what a bubble is:

“The most fundamental difficulties [in trying to describe oil prices] lie in the operational definition of a ‘bubble,’” Sornette told PhysOrg.com. “There is no consensus. One standard definition is ‘exponential growth of price.’ But exponential growth of price is normal in economics, because it just corresponds to a constant growth rate. Our definition is ‘faster-than-exponential' growth of the price, which is necessarily unsustainable.

We have what we think is a good working operational definition a bubble, which we'll present in the very near future.

In the meantime, we'll leave you with what the researchers see ahead in the oil market:

“I expect rather soon some calming with a correction of the price,” Sornette said when asked about his prediction of future oil prices. “But it seems that, for the medium term, one has to be bullish on oil.”

More Information

Here's the reference for the researchers' article:

Sornette, D.; Woodard, R.; and Zhou, W.-X. “The 2006-2008 Oil Bubble and Beyond.” Arxiv:0806.1170v2. 13 Jun 2008. Submitted to Physica A.

A PDF version is available here.

Update: Changed the last word of the first sentence of our third original paragraph from "effect" to "phenomenon," which better describes how we view bubbles!

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