Oil on the Way Down?

It’s easy to become fatalistic as the price of oil climbs ever higher. Many people assume that the price will never come back down and drivers are destined to pay at least four or five bucks for a gallon of gas, or more, far into the future.

But the price of oil is not destined to go in any particular direction, and a case can be made that it could drop in the near future.

For example, the June 4 Wall Street Journal ran a story titled “Is Oil the Next ‘Bubble’ to Pop?’” That piece noted:

Is there an oil bubble that is about to burst? Some big voices on Wall Street think so, predicting the oil market could tilt sharply south soon if the U.S. dollar strengthens and demand for crude oil weakens in some key consuming countries. Tightness on the supply side could also ease, they say, as some big refineries and new oil fields come onstream over the next few months and the outlook for the Chinese economy clouds over.

Or, consider what economist Alan Reynolds wrote in an op-ed that ran in the June 6 New York Post. He makes the case for a coming fall in the price of oil:

Two-thirds of petroleum in the United States is used for transportation - but half of the transportation sector's fuel flows into commercial trucks, trains, buses, airplanes and ships. As a result, only 44 percent of each barrel of oil is used to produce gasoline in this country, and some of that gasoline fuels business - delivery vans, landscapers' trucks, fishing boats, industrial and farm machinery, etc.

Most crude oil is used to produce diesel fuel for trucks, ships and trains, heavy fuel oil for industry, aviation fuel, asphalt, home heating oil, propane, wax, and innumerable petrochemical products ranging from detergents and drugs to synthetic fabrics and plastic.

In short, a huge share of crude oil is used to produce and distribute industrial products. That explains why the price of oil is extremely cyclical - that is, it tends to rise during economic booms and fall during contractions. It dropped 44 percent in the last recession (from November 2000 to November 2001), 48 percent from October 1990 to January 1992 - and 71 percent from July 1980 to July 1986.

Oil prices have a huge impact on producers' cost of production - profits and losses - not just on consumers' cost of living. Firms that can't raise prices will find profit margins squeezed - and will have to cut back on production and jobs. Even if some producers of energy-intensive products can raise prices enough to cover higher energy costs, they'll nonetheless sell fewer of their products because of those higher prices. So they too will have to cut back on production and jobs. Nine out of 10 previous postwar recessions began shortly after a big spike in the price of oil. Yet those recessions always slashed oil prices dramatically. People who have been predicting both a nasty US recession and $200 oil prices are contradicting themselves.

Unfortunately, the Reynolds’ scenario isn’t exactly cheery on the economy in general, but it is a realistic assessment of what happens to the price of oil as the economy grows and slows.

And the Journal’s point on the dollar is critical to keep in mind.