Speculative bubbles are common to any number of asset classes. The oil market is no exception, with numerous boom-and-bust cycles and periods of speculation dotting the past century. These bubbles significantly impact national and global economic performance and impact the lives of consumers given the integral role of oil as a resource.
Several groups of players dominate the oil trading environment and contribute to these cycles of speculation. Let’s first examine them to integrate within the grander speculative cycle:
- Speculators: investors who trade based on forecasts about oil prices. Speculators will trade derivatives of crude oil (futures, options, etc.) without ever taking ownership of the underlying asset, and they are physically not in the oil business.
- Commercial Traders: commercial oil futures and spot traders are those involved in the actual physical oil market; producers, refiners, distributors, etc. These organizations are primarily looking to hedge their bets (in pursuit of the “perfect hedge” whereas they are indifferent to price change) in the futures market.
- Arbitrageurs: arbitrageurs play on visible price differences, and trade those differences—e.g., given a $0.05 cheaper spot price at point B versus point A, buy at point B and sell at point A, then rinse and repeat—to turn a profit. Arbitrageurs are one of the fundamental driving forces in the unification and globalization of oil markets, as well as their tendency to move together.
- Noise Traders: noise traders are generally those who make trading decisions based on highly speculative information and are known for trading together via jumping in hype cycles and reinforcing their own beliefs via collective action. In theory, noise traders should go bust over time (since assets should reflect fundamental value, again, in theory), but since noise traders collectively shift risk, they can earn a higher return that arbitrageurs and otherwise advanced investors.
With these players in mind, note that a speculative bubble details an asset or market whereas prices have decouples from fundamentals — this ties into the equity notion of fundamental value and a “true price” that fundamental analysts seek to determine to understand the valuation of a company relative to where it should be.
Noise traders place bets that are irrational in a closed (individual) sense; purely on paper, without a market, they are practically guaranteed to go bust over time given trading decisions based on speculative data (this is coming from someone that wrote a book on technical analysis!).
However, the power of noise traders and their ability to increase the likelihood of a bubble comes from their cumulative mass and self-reinforcing behavior whereas noise traders often leverage the same signals and make the same decisions based on such.
By the cumulative mass of noise traders trading as if x will happen because of y, y actually happens irrelevant of fundamental price action, with a positive feedback loop continuing that snowballs into covered margin positions, short squeezes, media exposure generating further investment, etc., all based on the notion that price decouples from fundamental value, informational advantages are rendered obsolete, and noise traders accidentally work together to justify their own existence in markets.
With this in mind, institutional traders and oil producers can inadvertently contribute to a bubble caused by noise traders—or for any other reason—by continuing to buy the asset (futures as a hedge, popular stocks to divest and make investors happy), having to liquidate short positions, and perhaps becoming joining the frenzy out of greed.
To conclude, the specific sequence of actions that lead to speculative bubbles in the oil market and elsewhere is this:
- Noise traders push oil prices to the upper level of the fundamental value range.
- Oil producers engage in arbitrage & short hedge, ideally to return prices to their fundamental ranges.
- Institutional investors continue to buy futures.
- Institutional investors push price rise well beyond fundamental range.
- Producers lose informational advantage and remove short hedges to limit losses.
- Buy crude oil futures to offset short positions; become positive feedback traders.
- Consumers lose informational advantage; essentially become positive feedback traders.
- Negative feedback traders/contrarians are losing money and must liquidate positions; become positive feedback traders.
- As per positive feedback trading, prices rise.
- Bubble bursts.