Why oil prices will tank

[Hitchhiker]

Interesting 'Fortune' article, hope it's right:


Why oil prices will tank


Arguments that $4-a-gallon gas (or even higher) is here to stay are dead wrong. Housing's boom-and-bust cycle tells you why.

By Shawn Tully, editor at large

NEW YORK (Fortune) -- High-flying tech stocks crashed. The roaring housing market crumbled. And oil, rest assured, will follow the same path down.

Not everyone agrees. In an echo of our most recent market frenzies, some experts pronounce that the "world has changed," and that the demand spikes, supply disruptions, and government bungling we face now will saddle us with a future of $4, $5 or even $10 a gallon gasoline.

But if you stick to basic economics, it's clear that the only question is when - not if - prices will succumb.

The oil bulls are correct in their explanations of why prices have jumped. It's indisputable that worldwide demand has surged, chiefly driven by strong growth in China, India and the Middle East. It's also true that most of the world's reserves are controlled by governments in places like Russia and Venezuela that mismanage production, thus curtailing supply growth.

But rather than forming a permanent new plateau for prices - as the bulls contend - those forces are causing a classically unstable market that's destined for a steep fall.

In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.

So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."

But today, the sudden surge in demand and the production bottlenecks have thrown the market radically out of balance.

Almost exactly the same thing happened in the housing market. And both housing and oil supply react to a surge in demand with a long lag. In housing, the lag is caused by restrictive zoning and development laws, especially in coastal markets like California and Florida.

So when the economy roared back in 2002 and 2003, builders couldn't turn out homes fast enough for buyers armed with those cheap mortgages. As a result, prices spiked. They no longer bore any relation to the actual cost of buying and improving land, or constructing and marketing a new house (at some reasonable profit margin). Instead, frenzied buyers were setting the price.

Because builders were reaping huge windfall profits, they rushed to buy and develop land. And sure enough, those new houses were ready just as buyers were retreating to the sidelines because they could no longer afford to buy a home. That vast overhang of unsold homes is what's driving down prices today.

The story is much the same with oil, with a twist. A big swath of the market isn't really paying that $125 a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.

But sooner or later the world won't keep paying those prices: Eventually, the price must fall back to the cost of that last barrel to clear the market.

So what does that barrel cost today? According to Stephen Brown, an economist at the Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.

It takes a while to develop new supplies of oil, but the signs of a surge are already in place. Shale oil costing around $70 a barrel is now being produced in the Dakotas. Tar sands are attracting investment in Canada, also at around $70. New technology could soon minimize the pollution caused by producing oil from our super-plentiful supplies of coal.

"History suggests that when there's this much money to be made, new supplies do get developed," says Brown.

That's just the supply side of the equation. Demand should start to decline as well, albeit gradually.

"Historically, the oil market has under-anticipated the amount of conservation brought on by high prices," says Brown. Sales of big cars are collapsing; Americans are cutting down on driving. The airlines are scaling back flights.

We've learned another important lesson from the housing market: The longer prices stay stratospheric, the worse the eventual crash - simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce.

It's even possible that, a few years hence, we could see a sustained period of plentiful oil supplies and low prices, meaning $50 or below.

A similar scenario occurred following the price explosion in the 1970s and early 1980s. The price spike caused the world to cut back sharply on oil consumption. By the mid-80s, oil prices had fallen from almost $40 to around $15. They remained extremely low for two decades.

It's impossible to predict how the adjustment this time will take shape, just as it was in housing. There the surge in supply came in places the experts swore there was "no supply," and wouldn't be any. Builders found a way to extend vast tracts of homes into California's Inland Empire and Central Valley, and even build "in-fill" projects near the densely-populated coasts.

An earlier bubble is also instructive. In the early 1980s silver prices jumped from $10 to $50 on the theory that the world was facing a permanent shortage of silver. Suddenly ads appeared asking homeowners to bring their tea sets and jewelry to Holiday Inns for a big price. Silver supplies poured from seemingly nowhere, out of America's cupboards, of all places.

And so it will be with oil. We don't know where the new abundance will come from, from shale, or tar sands or coal or an OPEC desperate to regain market share. We just know that it will appear. With prices like these, it always does.

[Hitchhiker]

Interesting 'Fortune' article, hope it's right:


Why oil prices will tank


Arguments that $4-a-gallon gas (or even higher) is here to stay are dead wrong. Housing's boom-and-bust cycle tells you why.

By Shawn Tully, editor at large

NEW YORK (Fortune) -- High-flying tech stocks crashed. The roaring housing market crumbled. And oil, rest assured, will follow the same path down.

Not everyone agrees. In an echo of our most recent market frenzies, some experts pronounce that the "world has changed," and that the demand spikes, supply disruptions, and government bungling we face now will saddle us with a future of $4, $5 or even $10 a gallon gasoline.

But if you stick to basic economics, it's clear that the only question is when - not if - prices will succumb.

The oil bulls are correct in their explanations of why prices have jumped. It's indisputable that worldwide demand has surged, chiefly driven by strong growth in China, India and the Middle East. It's also true that most of the world's reserves are controlled by governments in places like Russia and Venezuela that mismanage production, thus curtailing supply growth.

But rather than forming a permanent new plateau for prices - as the bulls contend - those forces are causing a classically unstable market that's destined for a steep fall.

In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.

So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."

But today, the sudden surge in demand and the production bottlenecks have thrown the market radically out of balance.

Almost exactly the same thing happened in the housing market. And both housing and oil supply react to a surge in demand with a long lag. In housing, the lag is caused by restrictive zoning and development laws, especially in coastal markets like California and Florida.

So when the economy roared back in 2002 and 2003, builders couldn't turn out homes fast enough for buyers armed with those cheap mortgages. As a result, prices spiked. They no longer bore any relation to the actual cost of buying and improving land, or constructing and marketing a new house (at some reasonable profit margin). Instead, frenzied buyers were setting the price.

Because builders were reaping huge windfall profits, they rushed to buy and develop land. And sure enough, those new houses were ready just as buyers were retreating to the sidelines because they could no longer afford to buy a home. That vast overhang of unsold homes is what's driving down prices today.

The story is much the same with oil, with a twist. A big swath of the market isn't really paying that $125 a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.

But sooner or later the world won't keep paying those prices: Eventually, the price must fall back to the cost of that last barrel to clear the market.

So what does that barrel cost today? According to Stephen Brown, an economist at the Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.

It takes a while to develop new supplies of oil, but the signs of a surge are already in place. Shale oil costing around $70 a barrel is now being produced in the Dakotas. Tar sands are attracting investment in Canada, also at around $70. New technology could soon minimize the pollution caused by producing oil from our super-plentiful supplies of coal.

"History suggests that when there's this much money to be made, new supplies do get developed," says Brown.

That's just the supply side of the equation. Demand should start to decline as well, albeit gradually.

"Historically, the oil market has under-anticipated the amount of conservation brought on by high prices," says Brown. Sales of big cars are collapsing; Americans are cutting down on driving. The airlines are scaling back flights.

We've learned another important lesson from the housing market: The longer prices stay stratospheric, the worse the eventual crash - simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce.

It's even possible that, a few years hence, we could see a sustained period of plentiful oil supplies and low prices, meaning $50 or below.

A similar scenario occurred following the price explosion in the 1970s and early 1980s. The price spike caused the world to cut back sharply on oil consumption. By the mid-80s, oil prices had fallen from almost $40 to around $15. They remained extremely low for two decades.

It's impossible to predict how the adjustment this time will take shape, just as it was in housing. There the surge in supply came in places the experts swore there was "no supply," and wouldn't be any. Builders found a way to extend vast tracts of homes into California's Inland Empire and Central Valley, and even build "in-fill" projects near the densely-populated coasts.

An earlier bubble is also instructive. In the early 1980s silver prices jumped from $10 to $50 on the theory that the world was facing a permanent shortage of silver. Suddenly ads appeared asking homeowners to bring their tea sets and jewelry to Holiday Inns for a big price. Silver supplies poured from seemingly nowhere, out of America's cupboards, of all places.

And so it will be with oil. We don't know where the new abundance will come from, from shale, or tar sands or coal or an OPEC desperate to regain market share. We just know that it will appear. With prices like these, it always does.

[sgtjoe]

Wonder what kind of odds they're giving in Vegas on oil prices dropping?

[Jestme13]

With all the Harvard and Warton school educated oil people in the Opec coalition, I have no doubt they to will figure out your theory. They must have a plan to maximize there profits on their fixed assets.

But, like many others, I sure hope your right.

[Route 66]

I have read several articles along these lines.

One can only hope the bubble will burst.

[Hillbilly2]

All we need is one OPEC nation to get greedy, and want more share of the market, then they will start producing more, starting a price war if we are lucky.

[Hitchhiker]

Today's jump of $11 a barrel sure makes you question a price tanking theory, doesn't it?

[Kablewizard]

Yea, the price of diesel just started to drop, last week it was 4.79 around here, and 4.66 at Loves wed it was 4.69 around town and 4,55 at loves guess it going up again. Darn

[Spoonman]

I`m hopin the theory is correct and it happens in my lifetime, but the number of RVs for sale in the classified section says there isn`t too much confidence short term.

[Ding-a-ling]

Three weeks ago I sat in on a financial seminar at which the Chief Financial Analyst of a major national investment company spoke.

He reported virtually the same story and predicted it would occur later in 2008.

[GaryKD]

You're OP is correct. It is the way a free market works. Even OPEC can not control an inflated price forever. For me, the only difference between now and in the past is that the playing field for the world (economically speaking) is flat. This may mean the excessive swings may be more of a bell curve than a spike and cliff.

For me, this is more than fuel prices. It is difficult to see history being made, when you are living through it. The standard of living in the USA has been far above all other countries. This too may be part of a bell curve we (the USA) must work through. We now compete with the rest of the planet for every $ of revenue/income and everything we consume.

In the last half of the 20th century we have seen a rebalancing of many countrys' economies and standard of living. Western European countries, England and Japan to name a few. Even Mexico had an awakening from 1999 through 2003, when their economy became too expensive. It was easy to see this because it was happening to somebody else.

The world economies and the technologies that support growth and economic leadership are moving forward at a pace never before seen, in all of recorded history. What may frighten many of us is that the unknown is changing faster than we can grasp any individual solution.

For those who have family members in school consider advising them to do their homework and make their career their passion (not just a job). Kids in emerging countries are doing just that.

[Hitchhiker]

<BLOCKQUOTE class="ip-ubbcode-quote"><div class="ip-ubbcode-quote-title">quote:</div><div class="ip-ubbcode-quote-content">He reported virtually the same story and predicted it would occur later in 2008.
</div></BLOCKQUOTE>

Personally, I don't see it happening that soon, if we're lucky maybe 2009 or 2010. Since the oil price run up is global, there needs to be some sort of world wide event to trigger a slide. Not sure what that would be though.

Maybe a world wide recession, ending the war in the Mid-East, or termination of government subsidies in some of the communist countries would turn the tables of the price run up. Something needs to happen to break the overly exuberant speculation by those investing in this stuff.

Maybe a major breakthrough on alternative energy sources would stop it. Whatever it is it needs to come soon or this country will go into another depression of the type we saw in the thirties.

[evan0810]

The problem can totally be traced to Washington DC. We (the US) have a 200 yr supply of oil not counting the oil shale that has been found. Bill Clinton vetoed the bill that would have allowed drilling the new fields in Alaska and now we are paying for it. None of these "green" politicians want off shore drilling while the red Chinese are drilling off the coast of Florida now. Nobody (Ted Kennedy for one) wants a wind farm because it would destroy the scenery. We could be energy independant from some of our enemies, but there is always someone to stop it. We need to find out who is getting rich off of this situation. I think we'd find it isn't necessarily the oil companies. I venture to say that it is some of these idiots that were voted into office. I'm all for alternative energies, but our economy is being destroyed needlessly. GM just closed four truck factories, at least 3 RV manufacturers have gone out of business and the "trickle down" has just begun.

[Roam America]

last week I paid 4.499 for diesel. this week it is 4.399.