Why the Oil Price Will Correct Itself

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Yesterday, we mentioned the oil market. Today, we slide in deeper.

You’ll recall, dear reader, some time ago we guessed that the feds’ efforts to keep consumers consuming were essentially inflationary…and that the inflation they caused would tend to go more into gold and oil than into economic growth or asset prices.

Since then, the price of oil has shot up over $100. Yesterday, it hit a new record at over $126, before falling back to $124. Gold, meanwhile, has traded above $1,000 – and now is correcting in the mid-800s.

This is already a major adjustment. It comes along with a major adjustment in the purchasing power of the dollar, generally. Americans’ global purchasing power has been cut in half. The value of their assets – on the world market – are only half what they were during the Clinton years. And the value of their most precious asset – their time – has also been greatly reduced.

This is why you see so many Europeans in the United States…America is a cheap place to visit. It’s also why U.S. export industries are reviving; the country has become a low-cost producer for many things; it is now a place where richer nations can consider outsource production.

All of this has gone almost ‘according to plan’ – that is, it is pretty much what we guessed would happen.

But now, we have to ask: are these adjustments enough?

You’re expecting us to say ‘no,’ aren’t you? Instead, our answer is ‘maybe.’

In the case of America’s 50% pay cut, (the U.S. dollar is only worth about half as much as it was compared to other major currencies) we think it should do the trick. Now comes a long period in which people come to realize it and begin living not quite as large as before. They lose their houses. They cut back on their spending. They relearn an old word – thrift – and find they like it. They downsize their lives – with smaller houses, smaller cars, and littler expectations. The economy goes into a long slump – as 70 million people, facing retirement, begin to save money.

In the case of gold, our guess is “probably not.” Gold has still not come near the inflation-adjusted peak it set 28 years ago. Considering all that has happened during those years, we bet that there is another peak to come – even higher than the last. In 1980, the United States still had the residual financial integrity to stand up to inflation. Paul Volcker could push the yield on the 10-year Treasury note up to 16%; he caused a recession, but not a revolution. Most importantly, he protected the dollar. We don’t see any Volcker around now…and we don’t see how anyone – even Paul Volcker himself – could “pull a Volcker” now.

The country has twice as much debt per person. It has a hugely negative current account. It has the biggest government deficit ever (think what would happen to it in a real recession…the deficit would go to $1 trillion). No, we don’t think gold is in danger of a sudden attack of monetary propriety. Instead, we think the gold bull market has much further to go – probably above $2,500 an ounce, before the dollar-based financial system collapses completely.

But it is oil we set out to reckon with today. And what we reckon is that oil is getting close to its near term peak. If we were holding major positions in oil, we would sell them.

Here’s why. While gold is nowhere near its record high – oil is above it. In today’s money, the top price ever paid for a barrel of oil, until recently, was only about $79. Today, oil seems to be headed to twice that level. And a few experts think it will go much higher. Goldman’s oil expert predicts $200 oil.

But why should it go so high? For all the talk about China’s insatiable demand, it is still true that prices and demand must worth themselves out. When the price goes up, people grumble…but they use less. We filled our tank in France last weekend. The total price came to more than $150. We had been thinking about driving down to the South of France next weekend. Instead, maybe we’ll take the train…the trip would have cost us more than $300 in gasoline alone.

Everything happens at the margin, said a dead economist. Americans alone probably drive millions of marginal miles – to places they really don’t really need to go…when they don’t really have to be there. At over $3.50 – they’ll drive less. Already, the Financial Times reports that U.S. demand is falling more than expected.

There’s so much shifting sand in the oil market – usage, new discoveries, distilling capacity, storage facilities, OPEC policy, inflation, drilling technology, emerging market developments, the dollar, U.S. economic growth – its impossible to know how big the dunes will get. But oil demand – and prices – should generally stay in line with GDP. The more growth, the more oil. Plus, if you measure GDP and oil in dollars you eliminate both inflation and currency depreciation as variables. Well, at $100, reports Martin Wolf in the Financial Times , “the annual value of world oil output would be close to $3,000 bn. That is 5% of world gross product. The only previous years in which it was higher than that were 1979 to 1982.”

Those were not good years to enter the oil business. The price subsequently collapsed.

Yes, you could make a lot of money in oil…many people already have. But sure as fleas come with stray cats, success leads to excess. As the price rises, more and more people imagine that it will keep going up. Some take measures to avoid using it. Some find substitutes. Some increase production. Markets still work, in other words. Every bubble eventually finds its pin. The day can’t be too far off when the price of oil will fall back under $100.

Bill Bonner
The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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Comments

  1. Although I don’t particularly like to defend Dan Denning, I believe that it is the oil bubble that has caused the lack of investing enthusiasm in some of the alternative energy stocks. The reason for this I believe is that oil stocks are just so much more appealing whilst they are in this bubble. As far as longer term stocks go however, I think he has the right idea with his alternative energy stock picks.

    And guess who sold LNC at $1.40… me :(

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  2. what about the peak oil theory? oil is a finite resource that is the lifeblood of the world economy, world use is projected to increase to 117 million barrels per day by 2025-2030, which means supply the size of which OPEC currently delivers onto the market will have to be found. Where is that much oil going to come from? If prices do fall, that is only going to encourage more consumption, driving them back up even more in the longer term.

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  3. Google Lindsay Williams. And she sayeth unto the Lord, “And shall we forever be, as thick as two bricks?” And the Lord sayeth, “Yes.”

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  4. Good comment by Viv. Peak Oil is a huge worry – whenever it comes, and terrifying if it is already here – as some say. Would like to see someone as incisive as Bill Bonner have a good look at the Peak Oil theory. A good place to start is http://www.theoildrum.com which has a lot of oil exploration engineer types posting their technical based views as to why we’re facing a huge global challenge.

    I recently met a retired former chief engineer of a large global oil exploration company – his view Peak Oil was “about now”. He said the world has enough natural gas – but it is not retooling the car factories and fuel infrastructure fast enough. Also that petoleum is necessary for aviation fuel and some other uses and should be conserved. Not burnt in SUV’s going to buy a pizza.

    ruckrover
    May 19, 2008
    Reply
  5. Hey, today we have Oil in CONTANGO!!! So much for the prices going down. Serious Issue.

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  6. Goldmember will have his day. Lihir’s prospects are looking good.

    Silverado
    May 20, 2008
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  7. It seems a simple introduction to Peak Oil theory would be worthwhile at this point. I’m by no means an expert but I have been reading The Oil Drum http://www.theoildrum.com/ for a few years so I think I have a grasp of the basics.

    Firsty, Peak Oil is not about running out of oil and by itself doesn’t say much about the price.

    Its about a peak in supply per day/week/year. The basic idea goes like this: The oil thats found first is also the stuff that easiest to get out of the ground, the stuff thats found later is harder to get and (this is the important part) we can’t get it out as fast. Therefore at some point, the amount of oil coming out of the ground per day will reach a maximum and decrease from then on (perhaps after a few ups and downs but generally fixed supply for a while).

    When you add in the idea that the harder to extract oil is going to cost more to get out and that we ‘need’ oil at whatever price you get the idea that prices will increase.

    The term used to describe this need is ‘inelastic’. If demand is inelastic, it doesn’t change much when the price changes. In the eyes of the average consumer they may be doing a lot to try and not use the car as much but how much is that marginal use as a percentage of the oil they indirectly use by importing goods and services?

    We have built world-wide transportation infrastructures on using oil to get around (not to mention all the petro-chemical plastics etc.). So, unless we have teleportation ready to be rolled out on an industrial scale, worldwide usage of oil is quite inelastic because the individual choices we make about our car usage are very small in comparision to this.

    For demand to decrease to a point where it has a significant impact on the price of oil when the supply of oil is either fixed or decreasing (i.e. past peak) you are talking about changing the infrastructure of the world!

    This is not something that is done overnight. If its done in a controlled way it will take time (and prices will keep on rising in the meantime). If its uncontrolled, you have the poorer countries outbid for oil and potentially their entire economy collapsing as their infrastructure grinds to a halt.

    All this of course assumes that:
    1. Supply is fixed/decreasing. i.e. Peak Oil is here or already past.
    2. Demand is inelastic. i.e. our individual changes in oil consumption decisions are too little and/or too late.

    I’m of the opinion that 1 is true but I don’t want to believe that 2 is. Looking at the world of today I see no reason to argue against it, I just don’t like the potential future that implies if we bury our heads in the sand.

    Either way, I’m trying to do my bit to change my individual habits and educate myself. I’d advise others to do the same.

    Reece Arnott
    May 20, 2008
    Reply

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