Oil Prices and Economic Reality

There's no reason to panic about rising costs


Right now, energy consumers can only envy the Greek King Sisyphus. He was condemned by the gods to spend his life pushing a boulder up a hill, only to see it roll back down again. Motorists and other fuel users seem condemned to push uphill forever, with never a downward respite.

In the past year, world crude oil prices have risen like a bottle rocket. In the last year, they have doubled. Since February, they have gone from less than $90 a barrel to $135 a barrel—a level that was almost unimaginable at one time, like three months ago.

And some experts say that someday, we'll look back fondly to the days of $4-a-gallon gasoline. Famed oilman Boone Pickens is betting oil prices will reach $150 a barrel. Goldman Sachs analyst Arjun Murti, one of the few to anticipate the recent price surge, says they could reach $200. That would mean pump prices of $6 a gallon.

All this is the result, we are told, of a devilish convergence of forces: tight supplies, geopolitical uncertainty and booming demand in countries like China and India. Since none of these is likely to change, the upward trajectory of prices won't either.

At the risk of ending up on Pollyanna's Christmas card list, allow me to differ. Oil prices are unpredictable, particularly in the immediate future, and it's easy to think of events that could force them higher—like, say, a war between the United States and Iran. But in the long run, there is every reason to think that the steep, rocky ascent we have been on will give way to a welcome downhill path.

I'm not alone in my optimism. Michael Lynch, head of an energy consulting firm in Massachusetts, told the Associated Press the current price of gasoline "is the peak or very close to it." Analysts at the investment bank Lehman Brothers say we are just as likely to see oil at $80 a barrel as at $200.

It's easy to take a trend line as eternal fate. The oil market may look particularly inflexible, given the finite nature of fossil fuel deposits and the insatiable needs of growing economies. But two important things in the oil market can change. One is demand. The other is supply.

Demand here is already in full retreat. People are abandoning SUVs for hybrids, taking mass transit and even venturing out on foot. "The average American motorist is driving substantially fewer miles for the first time in 26 years," reported USA Today recently. "Miles driven in February declined 1.9 percent from February 2006 before rebounding slightly for a 0.3 percent year-over-year gain in March." And that was before gas got to $4 per gallon.

Americans are not the only influence on oil demand, but they're the biggest one. We consume a quarter of the world's annual supply—three times more than China and eight times more than India. So if our consumption starts falling and keeps falling, the petroleum sector will quickly feel the effects.

The common assumption is that oil use in China and India will soar no matter what. But even on the other side of the planet, demand is inversely related to price. Pump prices have risen in China, and if American motorists are cutting back on travel, you can bet that Chinese drivers are doing the same.

The supply of oil is also related to the amount it sells for. It's not getting easier to find new reserves, but at $130 a barrel, a lot of companies are going to be looking really, really hard. They will also be reevaluating fields that couldn't be profitably tapped at $60 a barrel. The federal Energy Information Administration projects that U.S. production will rise 24 percent in the next decade.

The same factors should boost output abroad. OPEC members will face far more temptation to cheat on their production limits. "This year will be a year in which supply will be put into the market by stealth by OPEC countries and countries we call black-hole countries" such as China, Lehman Brothers energy economist Edward Morse told The New York Times.

Back in the 1970s, everyone thought the world was running out of petroleum. But spurred by huge price increases, production rose even as demand was falling. Before long, the world was awash in cheap oil.

Don't be surprised if it happens again.