Friday, January 19, 2007

Oil Prices on Slippery Slope

I've been doing quite a few hits on TV lately talking about oil prices. The two questions I'm asked the most are 1) why are oil prices falling, and 2) why aren't gasoline prices falling as much.

As is almost always the case, prices change due to supply and demand constraints. We've been seeing for some time now that there is plenty of oil around. In fact, the Saudis had been complaining about the lack of oil tankers to transport oil. That's because all the available tankers were already full and had no place to unload quickly. Furthermore, the mild winter (at least so far) in the Northeastern United States helped keep crude supplies at higher-than-expected levels.

So there is plenty of supply. What about demand? When gasoline prices hit $3 per gallon last summer, consumers suddenly woke up. For the first time in quite a while, average miles driven actually fell. Demand for gas guzzlers also fell. People started thinking seriously about car pooling and avoiding unnecessary trips. Overall demand is down.

This combination of greater-than-expected supplies and lower-than-expected demand has driven oil prices lower. Yet many consumers and commentators are complaining that gasoline prices haven't fallen in lockstep with oil prices. That's true, but that's normal. Gasoline prices lag oil prices. Yes, even on the way up. Nonetheless, gasoline prices and oil prices are highly correlated. In fact, the correlation coefficient for weekly price changes from June 2006 to the present is well over 90%.

Gasoline prices will go lower in the very near term. Especially if demand stays weak. As for the longer term, a cold snap in the Northeast will drive oil and gasoline prices higher. For the much longer term, demand in the U.S. may remain weak as we move toward alternatives such as ethanol, bio-diesels, and true hybrids. But that won't be enough to stem growing demand from India and China. This should keep oil prices firmly in the $40-60 range. I would be very surprised if prices ever fall below $30 again.