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Oil Bubbles

Falling real interests in the US, a weak dollar and an increasing demand from China led to a bubble on the market. In the long term, this bubble will burst.

Raw material experts were way off the mark time and again with their predictions. Why is it so hard to forecast the price of oil?

By Philip Faigle

[This article published in: ZEIT online 5/23/2008 is translated from the German on the World Wide Web,  http://www.zeit.de/online/2008/22/rohoel-prognosen.]

Why is the price of a barrel of crude oil setting new records, recently surpassing the mark of $135 per barrel? For many economists, explaining this is increasingly difficult. "This price can hardly be understood," admitted raw material expert Michael Brauninger who has concentrated on economic trends with the Hamburg World Economy Institute.

The experts are nervous. All too often their past predictions proved wrong. When a barrel of European Brent oil cost $40 in September 2004, Citigroup argued a price of around $30 would be reasonable. The rally on the oil market would soon end. The big French bank Societe Generale made a similar forecast. At the end of 2007 when the price for a barrel of oil approached $100, many analysts including the Goldman Sachs investment bank calmed the public with the assertion the crude oil price would soon fall to $80 a barrel. How could they be so spectacularly off the mark?

Experts today offer several explanations. The great interest of speculators in betting on rising crude oil prices was underrated. "There is a tremendous exaggeration on the market," Commerce bank analyst Eugen Weinberg says. Falling real interests in the US, a weak dollar and an increasing oil demand from China led to a bubble on the market. In the long term this bubble will burst, Weinberg warns. A massive shortage will suddenly break out and demand will grow so quickly that today's price will seem justified.

Here is another explanation. Influential players on the petroleum market like the International Energy Agency (IEA) revised their forecast. Earlier the IEA saw how demand soared and drafted its prognoses accordingly," said Brauninger from HWWI. "Now how the supply can grow in the future seems more important."In its 2008 world energy outlook, the energy agency based in Paris announced the most important 350 gas- and oil-fields were under close scrutiny and lowered its prediction for the world petroleum supply. This prediction alone now drives the price, the experts say.

Therefore Weinberg from the Commerce bank calculates that the price rally will continue a while. He does not exclude a level of $170 a barrel. The "house of cards will collapse" - when America's car drivers begin to react to the higher price of oil or there is a decline of the demand from China. "An exaggeration of such an extent won't last in the long run," Weinberg says. "In the long term I do not see a price of $30 or $200." The experts who predicted a price level of $80 were wrong.

With one thesis, the experts were obviously incorrect. In 2004, the US economist Jeremy Rifkin predicted that a storm would break ou9t over America's economy when the oil price rose over $40 a barrel. Rifkin was not alone with his opinion at that time.

Today Brauninger from the HWWI says: "The economy copes with an oil price of $136 better than expected." Rifkin manifestly underrated several factors that make life without oil easier for western industrial states. For example, flexible labor markets enable businesses to balance higher energy costs with layoffs.

This insures that wages will not rise as strongly as in the 1970s. This restrains the inflation pressure starting from rising energy prices. Something similar is true for the policy of the central banks that is regarded as more credible today than in the times of the oil crisis. Businesses use oil more efficiently today. They know the supply of oil will end sometime or other.

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