Oil & Gas Prices - What Next?

Recently, I have seen quite a few articles about the return of gas prices to $1.15-$1.25 per gallon based on the price of oil falling down to $15/bbl. There is certainly some merit to this, as oil prices are well off their highs of $78.40/bbl. and are now at around $63/bbl. Of course, I find this recent media frenzy suggesting rock bottom oil and gas prices odd considering 4-6 weeks ago, the articles being circulated suggested $100-$150 per barrel oil price by the end of 2006. What is further curious is that in any given week, you can find various articles - some hyping $100/bbl. oil and others hyping $10/bbl. oil. Barring an editorial error in which they put the decimal point in the wrong place, we have very different takes of what is going to happen.

As for me, I think it is more likely to see higher oil prices than lower in the coming years and we could very likely hit $80-$100 per barrel prices within the next 3-5 years. I would say that is more likely rather than $15/bbl. Granted, I am know energy expert or oil economics guru, but here is my two cents for what it's worth.

First, it is important to recognize that the price of oil is driven by the traders on the commodities exchanges. It is not controlled by the government, the military, OPEC, the oil companies, or anyone else with the exception of the traders. Certainly, the traders use information available to them and the signs provided by these groups, but it is the traders that trade up or trade down the prices of the contracts for delivery.

With this being said, all of the articles I have been reading on why oil prices will decline to as low as $15/bbl. are all driven by complex market dynamics and technical analysis theories. While there is certainly merit to this line of thought, and again I am no expert, it really seems as those that are theorizing $15/bbl. oil are grasping at straws. I call to mind Achem's Razor from the movie CONTACT: "All things being equal, the most simple explanation is probably the correct explanation."

For instance, on article discussed a complex, esoteric relationship between the hisorical price of oil, dating back to the early 1900s, expressed in 2006 dollars and drew a relationship between this benchmark and the price of a gram of gold. While I would not want to compete with the author's experience and knowledge in this arena, even if he is correct, I would have to venture to say the realities in the marketplace suggest higher priced oil rather than lower priced.

1. Global Consumption is Growing
The world is using a great deal of oil and that amount grows each year. While some statistics show that the rate of growth is slowing, every year, the world uses more oil. Even though production is high and inventories are rising, we are still using more and more oil. Basic economics: anything that is getting used more each day and there is only so much available will have upward pressure on prices. Additionally, should prices fall too low, it will actually encourage additional consumption and remove the focus from alternative energy sources. While we are still many, many years away from effectively reducing global dependence on oil, if there is no economic reason to do so, nothing will change and oil will be the primary source of energy. Since we are not really 'running out of oil' as there are a great deal of proven reserves in the world - some tapped, some not - if oil prices remain 'cheap' the world will be further encouraged to rely on oil. Again, supply and demand - demand grows,supply gets reduced, prices will go up.

2. China & India
This is likely the largest variable playing into the equation. Even when communist Russia was at its peak, its consumption does not even come close to rivaling that of China or India. Plus, Russia is a big producer of oil - China and India are not. Both of these countries are experiencing rapid industrial growth and even if their rate of growth slows, the oil consumption by each will continue to rise significantly. This variable is brand new and has never been a part of the marketplace before. Additionally, right now, the USA consumes roughly twice more oil than India and China combined on a daily basis. Take into the consideration that combined population of India and China are 8 times larger than the USA and it would not be surprising to see the ultimate daily need of these two countries be 2-6 times that of USA daily consumption. Additionally, the USA is showing no signs of reducing its dependence on oil and the populations of India and China are growing significantly faster than that of the USA. India and China have also been actively working together purchasing the majority of oil interests and securing contracts with large oil companies & government agencies in Nigeria, Sudan, and Iran. This was further represented by China's failed takeover of Unocal, a US company that was purchased by Chevron. Long story short, never before in the history of oil prices have these two countries been in the mix before and they will put substantial pressure on the oil market. Plus, neither of these nations has significant reserves or production capacity of their own.

3. High Prices = More Exploration
As mentioned before, the world is not 'running out of oil.' Well, in a sense it is, but it's not like we have pumped the last drop out of the earth. There are still huge reserves of oil left in the world. We know where it is - it is just that some is easier to get to than others. If prices are high, then it encourages additional exploration and of course provides oil companies the means to extract oil from the more difficult places. For instance, if oil is at $70/bbl. and it costs $40/bbl. to extract it from a location at the bottom of the ocean, then they will do so. However, if the cost is the same and the price of oil is at $20/bbl., well, then it's just not economically viable. It has been the high oil prices that have made possible the exploration and future extraction of the oil from the new find in the Gulf of Mexico. If prices drop too low, new exploration and extractions will slow down, causing upward pressure on the prices.

4. Lightning Does Not Strike Twice
Oil prices were at record lows in 1999 - close to $10-$15 per barrel. Nobody was watching back then and it allowed savvy investors and the oil companies to enormously profit as they purchased contracts for future barrels of oil for next to nothing compared to today's prices. This time around, the world is watching. Should the prices start to quickly fall, investors and other buyers probably will not wait for the drop to $15/bbl., but will start buying quickly helping to support the prices. We might see $40-$45 per barrel, but not $15, as the buying will rush in far before that price level.

5. OPEC Production Cuts
OPEC has already said it will cut production if prices fall too fast. This is not a move out of pure greed, but it is more of an effort to provide some consistency and stability to the oil market. Economies are fragile and cannot take volatile rises or declines in prices of any goods. As much as auto drivers might want to see $1/gallon gasoline again, to happen so rapidly is not just healthy for the overall domestic and global economy. OPEC knows this and obviously has been pushing its members to peak production capacity. If prices fall too low and OPEC maintains peak production capacity, then its members might as well just pump out barrels of water or sand rather than oil. If prices fall too much further, we will see production cuts - besides, if there is plenty of inventory on the market and demand is slowing, I guess the world does not need to be at peak capacity, right?

6. We're OK With High Gas Prices
This is a simplistic point as consumer gasoline consumption is not a monster factor on the price of oil. Sure, it factors in, but that is not what is driving the demand. Regardless, there was less complaining about gas pricing in the summer of 2006 when they were higher than summer of 2005 post Hurricane Katrina (when complaining was really bad). Additionally, those in Europe pay $5-$7 per gallon. There is still a great deal of room there.

There are other items that suggest higher oil prices will be the norm, such as government taxes and tariffs (e.g., $15/bbl. oil would be devastating for Alaska at this stage and illustrates the economic principle of market stability), but by and large, the above, in my opinion, represent more logical reasons why the price of oil will continue to be high. Furthermore, any weakness in which the price falls to certain lows will be met by great support. Besides, are we that lucky to see prices fall to $15 and then back to $80? Unlikely. We'll probably remain in the $45-$65 range for a while.