Get Ready for the Oil-Price Drop

Cato Institute ^ | June 5, 2008 | Alan Reynolds

[SeekAndFind]

The price of crude oil has jumped as high as $135 lately, up from $87 in early February. The news encouraged some Wall Street analysts to suggest oil might approach $200 before long. In fact, that's quite impossible: The world economy can't handle current energy prices, much less a big increase.

Which in turn means that oil prices will fall.

Market analysts often claim oil prices are almost entirely determined by supply. Demand is said to be insensitive ("inelastic") to price. The standard example is that many Americans have to drive to work and most gas-guzzling SUVs will still be on the road even if the affluent few can trade theirs for a Prius. Whatever the price, we'll pay it.

This idea rests on two fallacies. The first is to exaggerate the United States' importance when it comes to ups and downs in worldwide oil demand. In fact, America is using no more oil than we did in 2004.

The second fallacy is to greatly exaggerate the importance of passenger cars in the United States. It's true that Americans are driving less and buying four-cylinder cars - but that's not where we should be looking for serious "demand destruction."

Two-thirds of petroleum in the United States is used for transportation - but half of the transportation sector's fuel flows into commercial trucks, trains, buses, airplanes and ships. As a result, only 44 percent of each barrel of oil is used to produce gasoline in this country, and some of that gasoline fuels business - delivery vans, landscapers' trucks, fishing boats, industrial and farm machinery, etc.

Most crude oil is used to produce diesel fuel for trucks, ships and trains, heavy fuel oil for industry, aviation fuel, asphalt, home heating oil, propane, wax, and innumerable petrochemical products ranging from detergents and drugs to synthetic fabrics and plastic.

In short, a huge share of crude oil is used to produce and distribute industrial products. That explains why the price of oil is extremely cyclical - that is, it tends to rise during economic booms and fall during contractions. It dropped 44 percent in the last recession (from November 2000 to November 2001), 48 percent from October 1990 to January 1992 - and 71 percent from July 1980 to July 1986.

Oil prices have a huge impact on producers' cost of production - profits and losses - not just on consumers' cost of living.

Firms that can't raise prices will find profit margins squeezed - and will have to cut back on production and jobs. Even if some producers of energy-intensive products can raise prices enough to cover higher energy costs, they'll nonetheless sell fewer of their products because of those higher prices. So they too will have to cut back on production and jobs.

Nine out of 10 previous postwar recessions began shortly after a big spike in the price of oil. Yet those recessions always slashed oil prices dramatically. People who have been predicting both a nasty US recession and $200 oil prices are contradicting themselves.

Recent news reports have expressed surprise that the US economy appears much stronger than the famously gloomy predictions at the start of the year. Indeed, the surprising endurance of US manufacturing and exports is one reason oil prices rose as long as they did.

But note that a US recession isn't required to bring down the price of oil. All that's needed is industrial stagnation or decline in many other countries.

In the United States and Britain, industrial production is nearly flat - only 0.2 percent higher than it was a year ago. In many other countries, however, industrial production has dropped over the past 12 months. It's down by 0.7 percent in Japan, 1.1 percent in Austria, 2.5 percent in Italy and Denmark, 2.9 percent in Canada, 5.4 percent in Greece, 5.7 percent in Singapore and 13.3 percent in Spain.

In April, industrial production also fell in India and China. Shrinking industry around the world shrinks demand for energy in general - and for oil in particular.

When the price of anything gets unbearably high, it discourages demand. The resulting drop in sales, in turn, causes inventories to pile up and the price to come down. That has proven true of overpriced houses - and it will likewise prove true of overpriced oil. Also of interest

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Alan Reynolds is a senior fellow with the Cato Institute and the author of Income and Wealth.

[Poetgal26]

Does this mean gas prices are going to drop too?
Hopefully!

[pnh102]

KEEP DREAMING!

These myths get retold every time the price of oil shoots up. It hasn't happened, and it won't happen.

[allmost]

I think most extraction costs are no more than $60 a barrel. This looks like a bubble.

[TomGuy]

The world economy can't handle current energy prices, much less a big increase.

Yet oil prices hit all-time highs on Thursday AND Friday, even though earlier in the week, Rush was yip-yip-yahoo-ing a minor price drop, as he "predicted prices would fall."

[Virginia Ridgerunner]

You know, I've been seeing this same ol' BS for two years now, that there's a big oil bubble, that it's going to burst and burst big time, and that prices will ultimately drop back to $50 per barrel.

Ain't happened yet, and ain't gonna happen. The price is just going to go up and up, until we all have to park our vehciles and ride around in Chinese rickshaws pulled by illegal Mexicans.

[liberallarry]

But note that a US recession isn't required to bring down the price of oil. All that's needed is industrial stagnation or decline in many other countries.

In other words; Kill my children, rape my wife, but PLEASE spare me!

The Cato Institute is supposed to be a reputable think tank? If this article is a sample of what it produces, it sure isn't.

[allmost]

Two record jumps just after the obama confirmation.

[crghill]

People who have been predicting both a nasty US recession and $200 oil prices are contradicting themselves. Economics 101

[kjam22]

Eventually we’ll decide oil and the price of oil is a matter of national security, and we’ll go take what we want. And while liberals who have been claiming that the current Iraq war is about oil (which it wasn’t).... they’ll finally get the real thing.

[NRG1973]

I think most extraction costs are no more than $60 a barrel. This looks like a bubble.

The price of a commodity is determined by the markets...not the cost to produce. Gold is a commodity whose price is much greater than the cost to mine it...same thing with diamonds.

The current oil situation is not a bubble...its real. In 1997 the world sent a message to oil producing entities when it drafted the Kyoto Protocol. That message was "we won't be needing more of your oil in a decade or so". Oil producing entities got the message and, for the last decade, have not invested much in new production. Now we have seen demand go up over the last decade...not down. Guess what??? That means oil prices will remain high until either more money is invested in oil production or demand reverses itself and drops precipitously. The only problem with demand that drops precipitously is that it manifests itself in recessions.

[Carry_Okie]

Nine out of 10 previous postwar recessions began shortly after a big spike in the price of oil. Yet those recessions always slashed oil prices dramatically. People who have been predicting both a nasty US recession and $200 oil prices are contradicting themselves.

I wouldn't put this toward demand reduction as much as the price historically induced exploration with a lag between investment and coming to market that roughly corresponds to the duration of a recession. Then cheaper oil helps "fuel" the recovery.

What is different now is the degree to which the producing side has been restricted by regulation sponsored by major stockholders of the oil companies themselves with "charitable" donations to environmental groups. That's the dirty little secret I've been trying to get conservatives to understand for nearly seven years.

[NRG1973]

Rush Limbaugh = Pollyanna!!!

He only says that because he wants to defend Bush from Democrats who blame the GOP for high gas prices. Limbaugh needs to do some research about long term supply vs. demand.

[TomGuy]

Yes, and the Dems are going to keep it high because it feeds in to their ‘it’s the economy, stupid’ autumn campaign.

And the spineless Pubbies haven’t and won’t do much about it.

[This is the same pattern that has been playing since Nixon and the gas lines of the early 70s.]

[SengirV]

When people predicted $75 a barrel oil, EVERYONE here laughed at them. When people predicted $100 a barrel oil, EVERYONE here laughed at them. When people predicted $150 a barrel oil, EVERYONE here laughed at them. Now people are predicting $200 a barrel the Cato institute is saying they are foolish.

A lot of people are looking foolish.

[Bommer]

The world economy can't handle current energy prices, much less a big increase. Which in turn means that oil prices will fall.

Its not the World Economy yesterday that "predicted" oil would hit $200, it was Bear Sterns. So that means that any half-assed market "expert" can say "$300 oil" and boom there goes the price. I would make a law that any company predicting of a commodity price without solid basis or proof, that does not come true in 30 days, should be fined! Bear Sterns jerked up the price over what they think will happen, not any solid proof! This crap results is market panic and gorging us at the pump.

[allmost]

I don’t think you can blame, solely , Kyoto. This looks more like margin traders with low interest rate gone wild to me.

[bray]

If you like $4/gal, Thank Congress.

President Bush has been warning about this for 8 years and they defeated every sensible energy plan he proposed.

Pray for W and Our Troops

[TomGuy]

Rush Limbaugh = Pollyanna!!!

He only says that because he wants to defend Bush from Democrats who blame the GOP for high gas prices. Limbaugh needs to do some research about long term supply vs. demand.

Why! That's... that's sacrilege!

Heretic!

HERETIC!

==

LOL

[G.Mason]

Like the Japs in the thirtys.

" ... The shortage of oil was the key to Japan's military situation. It was the main problem for those preparing for war, and, at the same time, the reason why the nation was moving toward war. For the Navy the supply of oil was critical; for the Army it was always a limiting factor. And none of the measures taken to curtail civilian consumption or manufacture substitutes ever gave Japan enough of this precious commodity to free it from restraint by the Dutch, the British, and the ... "

LINK

ΜΟΛΩΝ ΛΑΒE

[kjam22]

Yep.... that’s where this is ultimately headed. When we threw Saddam out we should have colonized Iraq.

[NRG1973]

Yes, and the Dems are going to keep it high because it feeds in to their ‘it’s the economy, stupid’ autumn campaign.

I have suspected the same thing. For the Democrats, everything is wrapped up in winning the 2008 election...and I think they will it. But, the current situation (high oil prices, high food prices, and rising unemployment) is getting worse. I have a feeling that the Dems will take over in 2009 and then things will really start to snowball. They will have a hard time balancing a needed increase in oil production with their rabinous enviro-whacko base and will probably fail to turn things around. It could be that 2010 could be a big year for the GOP.

The only problem with that scenario is that the American people will be greatly harmed by the events that will ensue between now and 2010.

[NRG1973]

I don’t think you can blame, solely , Kyoto. This looks more like margin traders with low interest rate gone wild to me.

Margin traders could be whipsawed if oil producers hit the "Go" button on more oil production. But unfortunately they haven't built that capacity for that additional production...and the traders know that.

[allmost]

True.

[Minn]

It hasn't happened

What hasn't happened?

[TomGuy]

President Bush has been warning about this for 8 years and they defeated every sensible energy plan he proposed.

Yah think?????

Notice this from just a couple of weeks ago:

• Bush administration bars drilling in Arctic wetland

  Monday, May 19, 2008 7:21:51 AM · by thackney · 30 replies · 448+ views

  Reuters ^ | May 16, 2008 | Yereth Rosen

  ANCHORAGE, Alaska (Reuters) - The Bush administration on Friday proposed keeping potentially oil-rich wetlands in Arctic Alaska off-limits to drilling because of their ecological sensitivity, a reversal of its earlier plan. The Bureau of Land Management proposed a 10-year leasing moratorium for 430,000 acres of wetlands north and east of vast Teshekpuk Lake in the National Petroleum Reserve-Alaska. Environmentalists and local groups hailed the decision. "This plan provides a balanced approach to energy development and wildlife protection, and forms a solid basis for the Bureau of Land Management to proceed with an oil and gas lease sale later this year,"...

There are plenty of villains in BOTH parties. The Pubbies controlled the House from 94 to 06, the Senate from 01 to 06 and the White House from 01, and they have done very little. This 'crisis' has been impending since Nixon was president. It wasn't something that just grew overnight.

[Ulysse]

I noticed that.And then what do you think about it?

[Minn]

Now people are predicting $200 a barrel the Cato institute is saying they are foolish.

I predict $900 a barrel oil. Anybody who disagrees is foolish. Right?

[PSYCHO-FREEP]

Not one mention of China. It was all focused on the USA.

The rest of the whole Free World has cut back over the last year while China and India have made large increases to keep demand rising sharply.

Of course, it will eventually peak, but the price will remain high. OPEC will simply cut production if World demand lowers as they have repeatedly done in the past.

[Sherman Logan]

We also heard in previous price spikes in the 70s and 80s that oil would just keep going up.

[winodog]

Thats not how I read it.

[RFEngineer]

“This looks more like margin traders with low interest rate gone wild to me.”

Bingo. The Fed is loaning record amounts of money to banks at interest rates that are way too low given the risk environment. Since the Fed is now assuming all investment risk, why not keep bidding up oil futures?

It’s the old “double-up” strategy for gambling - if you keep doubling your bets, whether you win or lose, eventually you’ll end up making money (theoretically, and given an unlimited wager limit). This strategy actually does work quite well when you have a stooge (The Federal Reserve) taking the risk (and cost) for the losing bets, and the speculators taking all the profits for the winning bets.

Americans don’t realize that their tax money is indirectly being used to raise the price of oil. Boy, would they be pissed if they knew.

[WOSG]

Any links to the analysts prediction of $150/barrel oil?
I’d like to read it.

[allmost]

Elections have consequences.

[PSYCHO-FREEP]

We can only blame the American people for not paying enough attention to what is really going on. They need a good lesson in just that.

Maybe now they will learn and start to keep an eye on the outcome of their ignorant and lazy tendencies.

[TLI]

Two record jumps just after the obama confirmation.

You noticed that too eh?

[popdonnelly]

Regardless of how high the price of a barrel of oil goes, gasoline consumption in this country is going to go down. People are already opting for automobiles that get better mileage, and alternatives to using the car. I find myself thinking before I go somewhere, “Is this trip really necessary?”

[allmost]

It’s all fuzzy, but I guess it’s safe... I have no idea what you are talking about.

[abb]

Recommended reading:

http://www.amazon.com/Prize-Epic-Quest-Money-Power/dp/0671799320
The Prize : The Epic Quest for Oil, Money & Power

[allmost]

The world moving forward.

[Deo volente]

I've heard that gas prices here in Los Angeles went up an average of 10-15 cents just yesterday, in one day. I'm glad I filled up on Thursday. Most stations I saw on Friday morning were selling unleaded for around $4.39/gallon. So I expect to see $5.00/gallon very soon, because there's a lag time of several weeks between the rise in oil prices and when it materializes at the pump.

I've also noticed a lot of gas stations closing down in S.E. Los Angeles County. I drive around here a lot on my job, and I can't tell you the number of stations that have disappeared lately. There are long lines at the ARCO stations, which have the cheapest gas, usually 15 cents or so less than the other major companies.

[stockpirate]

Read this and I think you will agree the oil industry has already been Nationalized in the US;

It was common in those days, as it is in ours, to identify the Communists as leftist and the Nazis as rightists, as if they stood on opposite ends of the ideological spectrum. But Mises knew differently. They both sported the same ideological pedigree of socialism. “The German and Russian systems of socialism have in common the fact that the government has full control of the means of production. It decides what shall be produced and how. It allots to each individual a share of consumer’s goods for his consumption.”

The difference between the systems, wrote Mises, is that the German pattern “maintains private ownership of the means of production and keeps the appearance of ordinary prices, wages, and markets.” But in fact the government directs production decisions, curbs entrepreneurship and the labor market, and determines wages and interest rates by central authority. “Market exchange,” says Mises, “is only a sham.”

Mises’s account is confirmed by a remarkable book that appeared in 1939, published by Vanguard Press in New York City (and unfortunately out of print today). It is The Vampire Economy: Doing Business Under Fascism by Guenter Reimann, then a 35-year old German writer. Through contacts with German business owners, Reimann documented how the “monster machine” of the Nazis crushed the autonomy of the private sector through onerous regulations, harsh inspections, and the threat of confiscatory fines for petty offenses.

“Industrialists were visited by state auditors who had strict orders to examine the balance sheets and all bookkeeping entries of the company or individual businessman for the preceding two, three or more years until some error or false entry was found,” explains Reimann. “The slightest formal mistake was punished with tremendous penalties. A fine of millions of marks was imposed for a single bookkeeping error.”

Reimann quotes from a businessman’s letter: “You have no idea how far state control goes and how much power the Nazi representatives have over our work. The worst of it is that they are so ignorant. These Nazi radicals think of nothing except ‘distributing the wealth.’ Some businessmen have even started studying Marxist theories, so that they will have a better understanding of the present economic system.

“While state representatives are busily engaged in investigating and interfering, our agents and salesmen are handicapped because they never know whether or not a sale at a higher price will mean denunciation as a ‘profiteer’ or ‘saboteur,’ followed by a prison sentence. You cannot imagine how taxation has increased. Yet everyone is afraid to complain. Everywhere there is a growing undercurrent of bitterness. Everyone has his doubts about the system, unless he is very young, very stupid, or is bound to it by the privileges he enjoys.

“There are terrible times coming. If only I had succeeded in smuggling out $10,000 or even $5,000, I would leave Germany with my family. Business friends of mine are convinced that it will be the turn of the ‘white Jews’ (which means us, Aryan businessmen) after the Jews have been expropriated. The difference between this and the Russian system is much less than you think, despite the fact that we are still independent businessmen.”

As Mises says, “independent” only in a decorous sense. Under fascism, explains this businessman, the capitalist “must be servile to the representatives of the state” and “must not insist on rights, and must not behave as if his private property rights were still sacred.” It’s the businessman, characteristically independent, who is “most likely to get into trouble with the Gestapo for having grumbled incautiously.”

“Of all businessmen, the small shopkeeper is the one most under control and most at the mercy of the party,” recounts Reimann. “The party man, whose good will he must have, does not live in faraway Berlin; he lives right next door or right around the corner. This local Hitler gets a report every day on what is discussed in Herr Schultz’s bakery and Herr Schmidt’s butcher shop. He would regard these men as ‘enemies of the state’ if they complained too much. That would mean, at the very least, the cutting of their quota of scarce and hence highly desirable goods, and it might mean the loss of their business licenses. Small shopkeepers and artisans are not to grumble.”

“Officials, trained only to obey orders, have neither the desire, the equipment, nor the vision to modify rules to suit individual situations,” Reimann explains. “The state bureaucrats, therefore, apply these laws rigidly and mechanically, without regard for the vital interests of essential parts of the national economy. Their only incentive to modify the letter of the law is in bribes from businessmen, who for their part use bribery as their only means of obtaining relief from a rigidity which they find crippling.”

Says another businessman: “Each business move has become very complicated and is full of legal traps which the average businessman cannot determine because there are so many new decrees. All of us in business are constantly in fear of being penalized for the violation of some decree or law.”

Business owners, explains another entrepreneur, cannot exist without a “collaborator,” i.e., a “lawyer” with good contacts in the Nazi bureaucracy, one who “knows exactly how far you can circumvent the law.” Nazi officials, explains Reimann, “obtain money for themselves by merely taking it from capitalists who have funds available with which to purchase influence and protection,” paying for their protection “as did the helpless peasants of feudal days.”

“It has gotten to the point where I cannot talk even in my own factory,” laments a factory owner. “Accidentally, one of the workers overheard me grumbling about some new bureaucratic regulation and he immediately denounced me to the party and the Labor Front office.”

Reports another factory owner: “The greater part of the week I don’t see my factory at all. All this time I spend in visiting dozens of government commissions and offices in order to get raw materials I need. Then there are various tax problems to settle and I must have continual conferences and negotiations with the Price Commission. It sometimes seems as if I do nothing but that, and everywhere I go there are more leaders, party secretaries, and commissars to see.”

In this totalitarian paradigm, a businessman, declares a Nazi decree, “practices his functions primarily as a representative of the State, only secondarily for his own sake.” Complain, warns a Nazi directive, and “we shall take away the freedom still left you.”

In 1933, six years before Reimann’s book, Victor Klemperer, a Jewish academic in Dresden, made the following entry in his diary on February 21: “It is a disgrace that gets worse with every day that passes. And there’s not a sound from anyone. Everyone’s keeping his head down.”

It is impossible to escape the parallels between Guenter Reimann’s account of doing business under the Nazis and the “compassionate,” “responsible,” and regulated “capitalism” of today’s U.S. economy today. At least the German government was frank enough to give the right name to its system of economic control.

Here is the link for this article:

http://mises.org/story/47

[dennisw]

LOL This was published before the $10 one day jump in oil and most likely written before the cumulative $16 jump of the last two days

[JasonC]

It has happened, repeatedly, and will happen again. First some political stuff with Iran will blow up, however.

[dennisw]

.

[NRG1973]

We also heard in previous price spikes in the 70s and 80s that oil would just keep going up.

There are some major differences between now and the 1970's/1980's:

1. The USA (the world's largest oil consumer) produced over 85% of its own oil until 1986. We now only produce 33% of our own oil.

2. Two "new" major oil fields were opened up in the 1970'/1980's...the North Sea and the North Slope of Alaska. They helped to create an oil glut in the late 1980's. Both of those oil fields are now in decline.

3. China and India were not industrializing rapidly in the 1970's/1980's...they are now. In 1992 China produced more oil than they consumed. Now they are the world's #2 oil consumer and the world's #3 oil importer. There is no sign of their demand growth slowing.

4. OPEC got caught with excess capacity in the 1980's and the cartel weakened because they competed against each other. I'm sure they've learned from that experience and aren't going to let that happen again.

5. The global warming movement is telling most of the world that they must reduce their consumption of oil because it is a fossil fuel. So, oil producing entities are very cautious about bringing on additional drilling capacity. Even if the world continues to use more oil in the post-Kyoto environment the oil producers will simply let the price go up.

[TLI]

The world moving forward.

I envision a somewhat more circular motion, accompanied by the sound of rushing water.

[JasonC]

Do you think oil will cost $1000 a barrel when all the cars are parked?

Just nonsense. The writer is entirely correct about the economics of it.

Oil is in a bubble, those always go much farther than rational economists expect, but they also always end, just as they expect.

In the present case, speculation over war with Iran is the real non-economic driver that will determine scale and timing. But that the bubble will pop, is a foregone conclusion.

[New Perspective]

Its not the World Economy yesterday that "predicted" oil would hit $200, it was Bear Sterns. So that means that any half-assed market "expert" can say "$300 oil" and boom there goes the price. I would make a law that any company predicting of a commodity price without solid basis or proof, that does not come true in 30 days, should be fined! Bear Sterns jerked up the price over what they think will happen, not any solid proof! This crap results is market panic and gorging us at the pump.

And this from the Bear Sterns who need rescued by the Feds. I wouldn't put a lot of stock into what they say but for some reason these *&%(&%$()& jerks seem to know just how to jack up the price of oil futures.

[dennisw]

What do you think of Arabs Iranians Russians and other investing in our oil futures markets to jack up the price? That this is some of the speculation you hear about that if the speculative bubble gets pricked then oil goes for $60/barrel