Tuesday, May 27, 2008

Oil Established a (Temporary? All-Time?) High

Last week, oil futures topped out at around $135 on news that everyone thinks
that a barrel of oil is going to $150, $200, $500, or $1million.
However, some important, telling data lateweek led to a pullback that
may lead to something more significant.

Late in the week, the Department of Transportation reported that the
number of miles driven in March fell by nearly 5% year-over-year.
That five percent decline is an enormous number of miles – about 11
billion. The 11 billion miles not traveled saves an enormous amount
of gasoline; assuming 20 mpg (which may be too optimistic), 500
million gallons of gasoline weren't burned during March.

That huge decline may signal a serious shift in the willingness of
Americans to pay for gasoline. As gas crept up from $1.xx per gallon
a decade ago to about $3 nine months ago, consumers complained.
Simply complaining doesn't keep any money out of sheiks pockets,
however, and Americans kept purchasing the necessary gas to get to
work, take a trip to the mall, or run endless amounts of single

However, as economic conditions worsened in late 2007 and early 2008
while gas prices continued to rise, consumers finally complained with
their proverbial pocketbooks, and actually altered the way that they
live their lives. It appears as though $3.50+ gasoline IS finally
enough to alter driving and living habits for many penny-pinching

Econ 101 (it's actually Econ 102 at Penn State) preaches that gasoline
has a relatively inelastic demand curve – that is, since it's so
necessary to basic life in the US, consumers don't change their
purchasing habits very quickly. (Think about it – even if gas was
$10/gallon, could you stop commuting to work/school tomorrow?)
Usually, it takes a long time for inelastically-demanded goods to
exhibit weakening demand, as over a long period of time, people can
find alternative solutions (ride the bus, move closer to work, buy a
more fuel-efficient vehicle, etc.). The quick 5% drop seems to boldly
state "enough is enough."

Sentiment has clearly been changing for years – car companies now
advertise MPG, not just horsepower or number of cup holders. Dozens of
models of hybrids are now sold (and Toyota's Prius, the best selling
and most efficient hybrid, just passed the 1 million mark), and the
aforementioned complaining has been becoming louder and louder. Oil
executives were crucified on Capitol Hill last week (though I think
that the parading and harassing is an insult to the intellects of
Americans, if legislators believe that finger-pointing [at the wrong
people] will make Americans feel better).

There is also talk of raising margin requirements on energy trading,
which basically would lessen the value of the bets being placed on the
price of crude (and other commodities). A bigger issue, in my
opinion, is the funny money in ETFs like OIL (which tracks the price
of oil) and DBA (an agriculture index), which purchases the hard
commodities with money from individual investors. The massive amounts
of money being pushed into such ETFs have artificially raised demand
for the underlying futures, increasing prices further.

As permabulls cite ever increasing demand for petroleum as why it just can't go down, the DOT statistic pokes a big hole in their arguments. Yes, the third world will use more oil as people can buy cars and agriculture is mechanized. However, a movement towards efficiency in the United States will have a meaningful impact on worldwide consumption and could offset any increases in developing nations. If oil does stay at $130/barrel in an environment of commodity (and overall) inflation, all of the millions of Chinese and Indian people who were inches away from buying their first car may now have to allocate more of their would-be disposable income on food and other necessities.

OPEC seems to stand firm on not increasing production to ease prices. (Many people argue if they could up output if they even wanted to, but I won't comment on that). However, if OPEC wants a market to sell their oil to ten, twenty, or fifty years from now, they should be more concerned with keeping oil cheap. Finally, fully-electric cars are on the roads (Telsa makes a sportscar, GM is releasing the mass-marketed Volt within a few years), and it looks like they'll be powered by newly contracted wind farms and solar plants. (Okay, that's a bit of a stretch, but alternative energy facilities are quickly being built.) Another energy policy change that may soon occur is the opening up of the US Eastern Continental shelf, which has been off-limits to oil exploration and drilling. The US may couple growth in alternatives with domestically-produced crude filling the important niches. Real measures are finally being taken to counteract the rising cost of energy.

So, in my opinion, it's time for something to give. A minor policy
change, the closing of the so-called "Enron Loophole" (which allowed
the buying of commodities on multiple exchanges once the limit on one
was met), may have signaled a willingness for lawmakers to win votes
by changing laws. The United States is currently warehousing over 700
million barrels of crude in the Strategic Petroleum Reserve. If one
million barrel (or less) was released per day, any real supply/demand
issue would be completely negated and crude futures would plummet.
Increasing margin requirements would take some speculative money out
of the market, but the ETFs are purchasing their contracts with cash.
Though bulls argue that crude has much farther to run, the increase
past $100 really hasn't been backed by much tangible, actionable facts
– and as tidbits of information like the driving statistic surface, this oil bubble may deflate.

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