My Two Cents on Black Gold

Oil reached another intra-day high today of $110 a barrel.

The obvious and most talked about question surrounding oil is if the current price is reasonable. Well, let's examine this question from a few perspectives.

First, let's consider supply and demand. According to recent data from the Energy Department's Energy Information Administration (EIA), crude supplies jumped by 6.2 million barrels last week, more than three times the projected 1.6 million barrels. Additionally, gasoline supplies increased by 1.7 million barrels, far exceeding the expected 300,000 barrels increase. Finally, there is a healthy amount of current U.S. inventory at 224 million barrels, which is 22.3 million barrels above last year and 18.6 million barrels above the 5-year average. Oil consumption is expected to decline within the next few months due to further deterioration of the U.S. economy and warmer weather. From underlying supply and demand fundamentals, we can generally conclude a well supplied market.

Second, let's examine OPEC. Last week, the cartel decided to leave current production levels unchanged. However, OPEC, along with the EIA, project a continual decrease in demand, and the federal agency predicts an increase in non-OPEC production for the next few months. It is unlikely the cartel will increase production at the next meeting, but current expectations provide some cushion.

Third, we need to talk about speculation. The ever weakening dollar is contributing to the high price of oil as investors seek safety in commodities to hedge against inflation. The depreciating value of the dollar also reprices oil, sending it through the roof. However, most investors are buying up oil because it is the bandwagon hot ticket. According to an article on oil from the Associated Press today, "many traders are buying simply because others are buying." No one really wants to miss an opportunity to bag the elephant, so everyone keeps on buying, unrelated to fundamentals, and mass psychology continues to push up prices.

Finally, what do industry experts, pundits, and academics have to say about this? In an interview last week with Maria Bartiromo, ExxonMobil CEO Rex Tillerson said the current market does not suffer from shortages, and the high price of oil does not reflect market fundamentals. Various fund managers have expressed their caution of commodities, especially oil, and many predicts a commodity bubble burst. I have exchanged comments with Ross School of Business Prof. Scott Masten, who specializes in transaction cost economics. With regards to interest rates and the theory of exhaustible resources, Prof. Masten states, "it is hard to rationalize the high prices [of oil] we are now seeing on the basis of scarcity. For a while, it seems like there was an imbalance between world-wide demand and extraction and transportation capacity that was keeping prices higher than they should be. But with the economy slowing, and no major supply disruptions, prices should be falling rather than rising."

My prudent conclusion: Oil prices will fall, at least in the short-term, but not dramatically. I would be interested in knowing other theories or futures predictions on oil.