Bill Wade


Diesel Prices and Oil Prices Are a Classic Bubble

3 Reasons that Diesel Could Be $2.50 by Fall 2008

By Bill Wade

Oil prices climbed to their highest level ever, reaching over $118 per barrel this week. Truckers are feeling this price spike in their saddle tanks, with diesel breaking the $4.00 barrier. An analysis by Goldman Sachs even suggested that oil prices might soar to $200 per barrel! Would diesel continue its historic rise?

Does any of this price spiral make sense? Government statistics certainly don’t seem to support these levels…

  • Even though American crude inventories have fallen, gasoline inventories are the highest since March, 1993.
  • World oil production was up 2.5 percent in the first quarter of 2008 over the same 2007 quarter, while world oil consumption rose by just 2 percent.
  • World production will shoot up 3.3 percent in the second quarter and 4.1 percent higher in the third quarter than the same periods a year ago.
  • World demand is projected to rise by just 1.6 percent over the next six months.

Demand is falling in many industrialized countries. The U.S. consumed 4 percent less petroleum in January 2008 than it did the year before. Even China's demand for oil, which once rose at 10 percent per year, now will rise 6 percent per year. Worldwide surplus oil production capacity has gone from a very tight 1.5 million barrels per day a couple of years ago to more than 3 million barrels today.

So supply is up; relative demand is down and yet, the price of oil and thus diesel is soaring.

What's going on? While oil company profits are astounding in dollars, there has been little change in margins. Crude increases, and they process the same tonnage for the same profit but on a higher base.

Spokespeople for Big Oil have blamed a third of the recent run up in oil prices on the weak dollar, another third on geopolitical uncertainty and the rest on market speculation. Using their estimates and reasoning, consider these realities:

  • Oil consumers have watched warily as unrest in Iraq and Nigeria, war possibilities involving Iran and the antics of Venezuela's Chavez threatened to disrupt oil supplies. Most of those tensions have abated in recent months. True, most of the world's oil is produced in volatile regions by erratic governments. So the price of crude will always include some kind of political risk premium.
  • Most oil price contracts are denominated in dollars. The dollar has fallen in value by more than 30 percent against an index of major currencies since 2002. This means that the price of imports, including oil, have gone up. Continuing U.S. trade and fiscal deficits along with lower interest rates are not helpful on this front.

That brings us to speculation.

Since September 2003, the total number of open crude oil futures and options contracts rose by 375 percent. Meanwhile the global demand for petroleum rose by just 8.2 percent. So the futures and options market has become more important than the physical supplies in driving the price.
We are seeing investment flows into the oil market that don't have anything to do with the demand and supply of oil.

Investors are treating oil as a hedge against inflation and a falling dollar. In other words, the oil market is coming to resemble the gold market (which has also been soaring). Most gold traders don't even ask the question of how much gold was mined last year or how much spare gold mining capacity there is.

In the short run, oil prices are very inelastic: A large change in price produces only a small change in demand. Prices can fall as steeply has they rose.

If the price of diesel goes up a dollar per gallon overnight, you still have to fill your trucks and get to work. However, over the long run, consumers and producers respond to higher oil prices. Higher prices historically have encouraged innovation. Just look at the increases in MPG over the last 10 years for heavy trucks. Acceleration of this trend will certainly help drive down the price of oil.

Supply is also inelastic—it takes a long time (not to mention political will) to do the exploration, drilling and refining necessary to boost production in response to higher prices. This inelasticity of demand and supply means that petroleum prices are very sensitive to relatively small changes in either. Whenever you begin to hear market gurus decree that "this time it's different," as we did during the dot-com bubble and the housing bubble, that's a sure sign of danger in the market.

Proponents of the peak oil theory claim that the recent run up in prices is evidence that the end is near. Fears of peak oil are what this market has in common with the 1980s, not what is different. Recall that during the "oil crisis" of the 1970s when oil prices were as high as they are today, U.S. oil consumption declined by 13 percent between 1973 and 1983. The higher prices of the 1970s led eventually to an oil glut and prices fell to about $10 a barrel by 1986.

So what will happen to oil prices over the next few years? No one is predicting $10 per barrel oil. However, once the current bubble bursts, many believe that the price of crude will settle at around $60 to $70 per barrel in the next couple of years. But when? Timing a commodity bubble is impossible. (By definition- if you could time it, there would be no bubble!)

One rule is inviolate. "There are no free rides!" Noting the above, this certainly looks to be the riskiest time to be long in crude oil since 1980.

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