Lower gas prices won't last forever, economists warn

12/21/2008

The average price for a gallon of gasoline reached a zenith in Toledo in May at $4.19, and crude oil prices reached a record in July at $146.50 a barrel.

It changed lives. It crippled industries. It arguably ignited a global recession that rages unabated to this day. And for people such as Sara Ortolano of Monroe, who filled up this week for $1.65 a gallon, the wild swing in fuel prices makes no sense at all.

"I'd still like some answers of why the drastic swings. It doesn't make sense to the average consumer," said Mrs. Ortolano, who commutes daily from Monroe to her job as a manager at a West Toledo department store.

In just five short months, the oil market has tanked. Last week, even as oil producers promised to remove as much as 5 percent of their daily production, crude oil prices fell well below $40 per barrel - a stunning 75 percent decline in just five months.

But don't get too comfortable, economists and oil industry experts warn: Today's "cheap oil" will soon be replaced again with "peak oil" - and prices will rocket back up again.

"As soon as the world economy turns around, then prices will shoot higher again," said economist Ken Mayland of ClearView Economics LLC in suburban Cleveland. "As soon as those economies pick back up, we're going to be right back in the soup."

Mr. Mayland is talking about the economic theory of peak oil, the belief that oil production will or already has reached its maximum, and that as production declines, prices will rise accordingly. Peak oil theory, first proposed in 1956, may play out in a series of wildly speculative price swings that grow increasingly volatile over time, proponents say.

"World crude oil production stopped growing in 2005. It's hard to hide that one behind the curtain," argues Ken Deffeyes, professor emeritus of geology at Princeton University and a longtime proponent of the peak oil theory.

Advocates of peak oil theory believe that efforts to keep oil production high by extracting oil from more exotic locales, such as shale oils in Canada and the deep seas off Brazil, won't be able to keep up. And as demands for oil rise from a population that uses it for everything from transportation fuel to plastics to agriculture, competition for ever decreasing resources will increase exponentially.

Even as the price of oil continues to drop - it closed on Friday at $33.87 per barrel for delivery next month - the belief that it will quickly rise again has taken hold among those who make their living trading oil futures.

The Houston Chronicle last week described the current conditions in the oil market as "contango" - where futures contracts for later delivery of the commodity are higher priced than the ones for immediate purchase. There was a $10 per barrel higher price last week between crude futures for delivery in January vs. next June and a $15 higher price, up to $58 a barrel, for delivery in January, 2010.

That fact has oil speculators doing something unthinkable just six months ago - parking oil.

Bruce Kahler, a shipbroker at Lone Star, R.S. Platou, told Bloomberg News that Royal Dutch Shell is paying $86,000 a day and is parking the 2-million-barrel supertanker Leo Glory in the Gulf of Mexico for two to three months, when it can get higher prices for that crude.

"It's speculation," Mr. Kahler told Bloomberg. "These traders believe that 'if I put a cargo in there now, I will make money later.'"

That may be great for speculators, but it does nothing to explain to consumers such as Mrs. Ortolano why the cost to fill her tank went from $45 a year ago to $65 this summer to $25 on Thursday - or what the next few years may have in store.

Italian chemist Ugo Bardi, a proponent of "peak oil" theory, has laid out what he believes is the closest economic model to what's going on in the oil market. It's a familiar topic to anyone who's ever read Herman Melville's Moby Dick: whale oil in the 1850s.

Mr. Bardi, writing in May on the relationship between whale hunting in the 1850s - a la Captain Ahab - and current petroleum usage, found interesting similarities between the two.

"Whales are, of course, a renewable resource but if they are hunted much faster than they can reproduce, they behave as a nonrenewable resource; just like oil," Mr. Bardi explained. Whale oil production - and prices - peaked around 1850 at 12,500 gallons per year, then slid by more than 80 percent over the next 25 years as whales were hunted to near extinction.

"What we are seeing at present with crude oil is, most likely, one of these price spikes," he wrote. As oil demand curbs, as it has since he wrote this in May, "everyone will start screaming that the 'oil crisis' of the first decades of 21st century was just a hoax, just as it was said for the crisis of the 1970s."

But then, prices will spike, he wrote.

However, Mr. Mayland, the economist, said that what seem like wild fluctuations can be explained in terms of orthodox economic thinking.

"Oil," he said, "is something you don't want, but you need it. Oil is something that has no intrinsic value other than the energy function. You need it, but you don't want any extra."

He said what is going on at the pump is referred to as "price elasticity" - that is, the rate at which demand for a product such as gasoline drops when prices increase.

According to an analysis of more than 100 different studies of gasoline price elasticity published in the trade magazine Energy Journal, demand for gas drops by 2.6 percent for each 10 percent increase in price. As the demand falls, supplies increase and, in theory, prices come down.

The U.S. Energy Information Administration reported last week that prices continue to fall nationwide, as they have for the past 13 weeks. However, gasoline prices in the Midwest stayed steady last week, the first time since September that's happened in any region of the United States.

So what can the average consumer expect to see at the pump? Industry analysts and traders said we may be in a trough between two waves of higher gasoline prices. The bigger wave is in the rearview mirror, but prices are likely to begin to rise next year, they said.

Prices showing up on future-delivery markets seem to indicate a slow but steady rise for crude oil prices over the next few years. Traders of oil futures contracts point to a return of $2 gasoline by late spring or summer.

Tom Kloza, chief oil analyst for the Oil Price Information Service in Wall, N.J., wrote on his Web blog this month that some parts of the country, such as the Great Lakes states, could see prices plunge even further before a rebound starts next year.

"Don't be surprised to see some pump prices beneath $1.25 gal in states like Missouri, Illinois, Ohio, and Indiana," he wrote.

But Mr. Mayland said he worries the lessons from last summer's $4 per gallon gasoline may be lost amid current conditions. But he hopes the incoming administration saw what happened - and learned and pursues alternative energy development.

"I think with gasoline back down to $1.50 a gallon, there will be some backsliding [on conservation efforts]," he said. We're not going to be as careful arranging all of our trips like we were."

Contact Larry P. Vellequette at:

lvellequette@theblade.com

or 419-724-6091.