Lowering The Price Of Oil Through Supply Increases

Posted by jerry as finance

I have read and heard repeatedly by analysts, economists and politicians that say “drilling for oil is not going to do a thing for oil prices now”, mostly in response to the latest actions by George W Bush to allow off-shore drilling again.

I understand the logic behind those comments. Drilling for oil now means that we may have more supply in 10 years, because of the time to actually find where it is, and the infrastructure build duration. But, that assumes the price of oil is simply a matter of supply and demand. We have more demand than we have supply.As much as many people don’t want to hear it, we DO have enough supply, on a daily basis at least. It’s true that we are burning through a resource that will one day be completely gone, but we’re not there yet.

I strongly believe that the price of oil has been driven up far higher by speculation than any true supply constraints. An astute person should be able to intuitively see this happening. There is a relatively fixed amount of money in the world that is invested. Much of that money is held by relatively few investors, like hedge funds, mutual funds, and retirement funds. Those investors don’t like to have their money on the side lines. So, they will go from dumping money into poorly run tech companies, to financial companies, to real estate, and now to commodities like gold and oil.

It is certainly true that some amount of price increase is the result of inflation and low fed funds rates. But, we can’t carry that blame too far. Prices have tripled recently, and we have seen well less than a 50% move in the dollar in the same period.

The investors are speculating that we are running out of oil! We have China growing, along with the rest of Asia. They’ve got CARS in China, for Pete’s sake! There’s going to be a billion new cars on the roads soon!

But, it’s not to be. Just like the irrational exuberance, to steal a phrase, of the dot com and housing bubbles, a bubble is setting up in the commodities. Good news makes oil go up, bad news makes oil go up and there is always some news somewhere.

I strongly suspect that we are approaching a cliff in commodity prices. Each time a new oil reserve is found, we get pushed closer to the edge. It doesn’t matter that it won’t be producing for 10 years. It doesn’t matter that some day we will run out of oil. What matters is that the money managers begin to lose confidence that oil will continue to rise in price. Once that happens, we will see a large unwinding of crude prices quickly, as the big investors search for some new darling to invest in.

On the surface, falling energy prices sound like a great thing for the economy and inflation. There are two problems I see with dramatically falling energy prices:

1. A swift reduction in energy prices will almost certainly cause some amount of deflation in the dollar, and a disorderly repricing of the dollar will likely harm some part of the economy, primarily exporters and multi-national companies who have retooled to deal with the current economic situation.
2. The swiftly rising energy prices have created a boon in the energy sector, from the obvious oil and natural gas companies, down to the vast array of startups that are developing new forms of energy, many of which could not survive such a dramatic fall in oil prices.
3. The “burning platform” for the creation of energy alternatives is gone, at least for a while. If anything good has come out of the current energy situation, it’s the focus on conservation and cleaner & sustainable new options.

The longer we go without a correction in oil prices, the more dramatic the impact that the above issues will have on the economy.