"Neither 'bubble' nor 'China', but a 'China bubble'"

Daniel Gros, writing in the Financial Times, explains why oil prices are high:

What is behind the ever-increasing price of crude oil? Most economists and energy experts argue that even the current sky-high price is justified by fundamentals, namely the high growth in demand by emerging markets, in short “China”...

The big choice for any owner of an ex­haustible resource, such as King Ab­dullah of Saudi Arabia, is inter-temporal: extract today or extract to­morrow. If the king extracts today, he gets today’s price (minus the extraction cost). If he extracts tomorrow, he will get tomorrow’s price (minus the same extraction costs), discounted at today’s interest rate. The supply of oil today will thus increase only if tomorrow’s price is low relative to the price today.

In other words, the supply of oil will increase not when the price today is high, but only if suppliers expect that prices will be lower in future. This implies that China influences oil prices today not so much because Chinese demand is high today (China currently accounts for less than 10 per cent of global consumption of crude), but because demand in China is projected to increase so much in the future, fuelling expectations of higher prices and thus leading producers to lower their rate of extraction today. In this light, it is no mystery that oil supply has not reacted to higher prices. Rational oil producers are just waiting for even higher prices tomorrow...

[Since] speculators are not to blame, does it follow that there is no bubble in the oil market? Not necessarily. A bubble starts when past price increases lead to expectations of future price increases. It could very well be that prices will not increase as much as expected if China’s future demand for oil is lower than expected today, or if alternative energy supply sources become as cheap as some suggest...

In the meantime, the best explanation of oil prices is neither “bubble” nor “China”, but a “China bubble” – in the sense that speculators and oil producers are gambling on China’s sustaining high prices for ever.

In short, the bubble is Chinese growth itself. If we believe the straight-line predictions that say China will keep growing at 10% for the next 40 years, then we must conclude that oil demand - and oil prices - will be a lot higher in the future. So oil producers leave the oil in the ground, forcing up prices today.