When George Soros talks, world listens. He recently presented his views on rising oil prices to . The transcript of his speech is here.
His bubble theory:
According to my theory, every bubble has two components: a trend based on reality and a misconception or misinterpretation of that trend. Financial markets are usually very good at correcting misconceptions. But occasionally misconceptions can lead to bubbles because they can reinforce the prevailing trend and by doing so they also reinforce the misconception until the gap between reality and the market’s interpretation of reality becomes unsustainable. The misconception is recognized as a misconception, disillusionment sets in, and the trend is reversed. A decline in the value of collaterals provokes margin calls and distress selling causes an overshoot in the opposite direction. The bust tends to be shorter and sharper than the boom that preceded it.
He offers four factors for rising oil prices:
difficulty in finding new reserves
backward sloping supply curve of oil
Major exporters and importers keep prices artificially low
trend following speculation and institutional commodity index buying
He focuses on fourth factor and says:
Index buying is based on a misconception. Commodity indexes are not a productive use of capital. When the idea was first promoted, there was a rationale for it. Commodity futures were selling at discounts from cash and institutions could pick up additional returns from this so-called “backwardation.” Financial institutions were indirectly providing capital to producers who sold their products forward in order to finance production. That was a legitimate investment opportunity. But the field got crowded and that profit opportunity disappeared. Nevertheless, the asset class continues to attract additional investment just because it has turned out to be more profitable than other asset classes. It is a classic case of a misconception that is liable to be self-reinforcing in both directions.
I find commodity index buying eerily reminiscent of a similar craze for portfolio insurance which led to the stock market crash of 1987. In both cases, the institutions are piling in on one side of the market and they have sufficient weight to unbalance it. If the trend were reversed and the institutions as a group headed for the exit as they did in 1987 there would be a crash.
So Soros also believes speculation and index futures buying is leading to price rises. Michael Masters, Managing Member and Portfolio Manager , Masters Capital Management, LLC in his testimony to Senate Committee on Homeland Security and Governmental Affairs, also raised similar concerns. I a seeing market practitioners citing speculation as an important factor, most academicians don’t really agree.