The Perilous Price of Oil

The following is adapted from testimony given by George Soros before the US Senate Commerce Committee Oversight Hearing on June 3, 2008.

In January 2007, the price of oil was less than $60 per barrel. By the spring of 2008, the price had crossed $100 for the first time, and by mid-July, it rose further to a record $147. At the end of August it remains over $115, a 90 percent increase in just eighteen months. The price of gasoline at the pump has risen commensurately from an average of $2.50 to around $4 a gallon during this period. Transportation and manufacturing costs have risen sharply as well. All this has occurred at the same time as a world credit crisis that started with the collapse of the US housing bubble. The rising cost of oil, coming on top of the credit crisis, has slowed the world economy and reinforced the prospect of a recession in the US.

The public is asking for an answer to two questions. The principal question is whether the sharp oil price increase is a speculative bubble or simply reflects fundamental factors such as rapidly rising demand from developing nations and an increasingly limited supply, caused by the dwindling availability of easily extractable oil reserves. The second question is related to the first. If the oil price increase is at least partly a result of speculation, what kind of regulation will best mitigate the harmful consequences of this increase and avoid excessive price fluctuations in the future?

While I am not myself an expert in oil, I have made a lifelong study of investment bubbles as a professional investor. My theory of investment bubbles, explained more fully in my recent book, The New Paradigm for Financial Markets, is considerably different from the conventional view. According to my theory, prices in financial markets do not necessarily tend toward equilibrium. They do not just passively reflect the fundamental conditions of demand and supply; there are several ways by which market prices affect the fundamentals they are supposed to reflect. There is a two-way, reflexive interplay between biased market perceptions and the fundamentals, and that interplay can carry markets far from equilibrium. Every sequence of boom and bust, or bubble, begins with some fundamental change, such as the spread of the Internet, and is followed by a misinterpretation of the new trend in prices that results from the change. Initially that misinterpretation reinforces both the trend and the misinterpretation itself; but eventually the gap between reality and the market’s interpretation of reality becomes too wide to be sustainable.

The misconception is increasingly recognized as such, disillusionment sets in, and the change in perceptions begins to influence the fundamental conditions in the opposite direction. Eventually the trend in market prices is reversed. As prices fall, the value of the collateral used as security for loans declines as well, provoking margin calls. Holders of securities must sell them at distressed prices to meet the minimum cash or capital requirements, and…

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