NCPA - National Center for Policy Analysis

WHY OIL PRICES WILL TANK

June 12, 2008

Arguments that $4-a-gallon gas (or even higher) is here to stay are dead wrong.  High-flying tech stocks crashed.  The roaring housing market crumbled.  And oil, rest assured, will follow the same path down, says Shawn Tully, editor-at-large of Fortune magazine.

Basic economics make it clear that the only question is when -- not if -- prices will succumb, says Tully.  The same forces contributing to the jump in oil prices are causing a classically unstable market that's destined for a steep fall.

Consider:

  • A big swath of the market isn't really paying that $125 a barrel number often quoted in the media; in China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption -- and driving up prices even more.
  • When the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.
  • Eventually, the price must fall back to the cost of that last barrel to clear the market, which costs just $50 to produce, says Stephen Brown, an economist at the Dallas Federal Reserve.
  • The longer prices stay stratospheric, the worse the eventual crash -- simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce.

That's just the supply side of the equation.  Demand should start to decline as well, explains Tully.

For example:

  • Historically, the oil market has under-anticipated the amount of conservation brought on by high prices.
  • Sales of big cars are collapsing; Americans are cutting down on driving; and the airlines are scaling back flights.
  • In the 1970s and early 1980s, the price spike caused the world to cut back sharply on oil consumption; by the mid-80s, oil prices had fallen from almost $40 to around $15 and remained extremely low for two decades.

Source: Shawn Tully, "Why Oil Prices Will Tank," Fortune, June 9, 2008.

For text:

http://money.cnn.com/2008/06/06/news/economy/tully_oil_bust.fortune/?postversion=2008060608

 

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