The price for a gallon of gas has been setting new record highs averaging around $3.7. Well, if you are in California, there is a good chance that you are paying more than $4 already. If all else is not enough, Goldman Sachs predicted on Tuesday that oil could soar towards $150-$200 a barrel because of a lack of adequate supply growth. Supply is up, demand is down, yet the price is soaring. So what is the deal with oil??
Crude prices have more than doubled in the last one year causing pain to millions around the world. Many analysts believe the dollar’s protracted decline over the past year has much to do with the doubling in oil prices since May of last year. Another school of thought thinks growing demand in rapidly developing countries such as China, Brazil and India, is the primary factor driving oil higher. Others have also attributed speculation in oil and a wave of fund money pouring into commodities, given the weaknesses in other financial markets.
What effect does the falling dollar have on the price of crude? Most oil price contracts are denominated in dollars. The dollar has fallen in value by more than 30 percent against a Federal Reserve index of major currencies since 2002. This means that the price of imports, including oil, have gone up. That brings us to speculation. Since September 2003, the total number of open crude oil futures and options contracts rose by 364 percent. Meanwhile the global demand for petroleum rose by just 8.2 percent. So the futures and options market has become more important than the physical supplies in driving the price. We are seeing investment flows into the oil market that don't have anything to do with the demand and supply of oil. Investors are treating oil as a hedge against inflation and a falling dollar. Oil markets are part of a negative positive feedback loop in which higher oil prices contribute to higher inflation, which in turn lowers the value of the dollar, which boosts oil prices, and so forth. In other words, the oil market is coming to resemble the gold market (which has also been soaring).
Economists also note that in the short run oil prices are very inelastic: A large change in price produces only a small change in demand. If the price of gas goes up a dollar per gallon overnight, you still have to fill your tank to get to work. However, over the long run, consumers and producers respond to higher oil prices. For example, Americans are driving less and have switched to buying more fuel efficient cars. Higher prices are no doubt encouraging innovation.
Oil companies have a two-pronged approach when it comes to innovation: seek alternative sources of energy that will both (1) reduce dependency on trouble-some, oil-rich nations and (2) utilize this energy in a manner that will still reap windfall profits. Although ideal in theory, it’s much tougher to implement in practice since renewable energies are just that - renewable. When products are renewable, profits go down since consumers purchase less. There is no doubt that several companies have already innovated alternative fuels, however these will take years before reaching a scale of production where profits can be made from them.
So what will happen to oil prices over the next few years? No one is predicting $10 per barrel oil. However, it sure seems to be the right time to give up that Hummer and switch to hybrids as this problem is not going away anytime soon!!
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