Tuesday, September 05, 2006

Don't Get Too Exuberant Over Lower Gasoline Prices

With the futures price of unleaded gasoline down about 25% from its early August high, investors are asking if the recent energy "crisis" is finally over. A few things to keep in mind:

First of all, there never was a real energy crisis. The Arabs didn't boycott the U.S. and gasoline stations didn't run out of product.

There is no denying supplies are tight. The world is producing close to full capacity and it is consuming almost everything it produces. And there is little slack left in the system. Most major oil-producing nations can't produce more without making significant additional investments.

But there is also a "fear factor" at play. Oil prices didn't go up because of shortages. They went up because of potential shortages. Oil investors and speculators are justified in being worried. After all, there are reasons to worry about Iran, Venezuela and Nigeria. Iraq still isn't producing to its full potential. In fact, many the top oil producing nations are anything but stable. And of course, we saw what kind of damage a hurricane like Katrina can do oil and gas production in the Gulf of Mexico.

However, fear has suddenly abated somewhat in recent weeks. The United Nation's deadline for imposing sanctions on Iran has come and gone, and nothing much has happened. As for hurricane season, so far it hasn't been too menacing.

But something else is happening. Oil prices are down about 10% from their early August highs, yet gasoline prices are down 25%. Gasoline prices have also fallen much more than diesel prices. According to the latest reports, gasoline inventories are up more than expected.

I believe this is evidence of that vicious cycle I've talked about before. When gasoline prices rise, demand falls at the margin. When demand falls, prices recede. Lower prices then invite consumers to fill up the SUV again. Demand goes up, and so do prices.

Today's news that Chevron discovered new oil in the Gulf of Mexico is certainly good. It will keep prices from rising higher than they would have, but I seriously doubt prices will fall significantly. Chevron is rumored to have spent about $100 million to develop this deep-water well. This kind of investment is justified only if oil prices are expected to remain high. It wouldn't have made much sense for Chevron to spend so much money if it expected prices to fall back to $20 or $30 per barrel.

While it's certainly nice to see gasoline prices lower, we shouldn't get too exuberant. After all, prices are still about 45% higher today than they were just two years ago. Gasoline prices will have to go much lower to really boost consumer confidence.