From http://money.cnn.com/2008/06/06/news/econo...rtune/index.htm

Why oil prices will tank
Arguments that $4-a-gallon gas (or even higher) is here to stay are dead wrong. Housing's boom-and-bust cycle tells you why.
By Shawn Tully, editor at large
NEW YORK (Fortune) -- High-flying tech stocks crashed. The roaring housing market crumbled. And oil, rest assured, will follow the same path down.

Not everyone agrees. In an echo of our most recent market frenzies, some experts pronounce that the "world has changed," and that the demand spikes, supply disruptions, and government bungling we face now will saddle us with a future of $4, $5 or even $10 a gallon gasoline.

But if you stick to basic economics, it's clear that the only question is when - not if - prices will succumb.

The oil bulls are correct in their explanations of why prices have jumped. It's indisputable that worldwide demand has surged, chiefly driven by strong growth in China, India and the Middle East. It's also true that most of the world's reserves are controlled by governments in places like Russia and Venezuela that mismanage production, thus curtailing supply growth.

But rather than forming a permanent new plateau for prices - as the bulls contend - those forces are causing a classically unstable market that's destined for a steep fall.

What do you think: Is $4-a-gallon case here to stay?
In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.

So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."

But today, the sudden surge in demand and the production bottlenecks have thrown the market radically out of balance.

Almost exactly the same thing happened in the housing market. And both housing and oil supply react to a surge in demand with a long lag. In housing, the lag is caused by restrictive zoning and development laws, especially in coastal markets like California and Florida.

So when the economy roared back in 2002 and 2003, builders couldn't turn out homes fast enough for buyers armed with those cheap mortgages. As a result, prices spiked. They no longer bore any relation to the actual cost of buying and improving land, or constructing and marketing a new house (at some reasonable profit margin). Instead, frenzied buyers were setting the price.

Because builders were reaping huge windfall profits, they rushed to buy and develop land. And sure enough, those new houses were ready just as buyers were retreating to the sidelines because they could no longer afford to buy a home. That vast overhang of unsold homes is what's driving down prices today.

The story is much the same with oil, with a twist. A big swath of the market isn't really paying that $125 a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.

But sooner or later the world won't keep paying those prices: Eventually, the price must fall back to the cost of that last barrel to clear the market.

So what does that barrel cost today? According to Stephen Brown, an economist at the Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.

It takes a while to develop new supplies of oil, but the signs of a surge are already in place. Shale oil costing around $70 a barrel is now being produced in the Dakotas. Tar sands are attracting investment in Canada, also at around $70. New technology could soon minimize the pollution caused by producing oil from our super-plentiful supplies of coal.

"History suggests that when there's this much money to be made, new supplies do get developed," says Brown.

That's just the supply side of the equation. Demand should start to decline as well, albeit gradually.

"Historically, the oil market has under-anticipated the amount of conservation brought on by high prices," says Brown. Sales of big cars are collapsing; Americans are cutting down on driving. The airlines are scaling back flights.

We've learned another important lesson from the housing market: The longer prices stay stratospheric, the worse the eventual crash - simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce.

It's even possible that, a few years hence, we could see a sustained period of plentiful oil supplies and low prices, meaning $50 or below.

A similar scenario occurred following the price explosion in the 1970s and early 1980s. The price spike caused the world to cut back sharply on oil consumption. By the mid-80s, oil prices had fallen from almost $40 to around $15. They remained extremely low for two decades.

It's impossible to predict how the adjustment this time will take shape, just as it was in housing. There the surge in supply came in places the experts swore there was "no supply," and wouldn't be any. Builders found a way to extend vast tracts of homes into California's Inland Empire and Central Valley, and even build "in-fill" projects near the densely-populated coasts.

An earlier bubble is also instructive. In the early 1980s silver prices jumped from $10 to $50 on the theory that the world was facing a permanent shortage of silver. Suddenly ads appeared asking homeowners to bring their tea sets and jewelry to Holiday Inns for a big price. Silver supplies poured from seemingly nowhere, out of America's cupboards, of all places.

And so it will be with oil. We don't know where the new abundance will come from, from shale, or tar sands or coal or an OPEC desperate to regain market share. We just know that it will appear. With prices like these, it always does.

Good article.

Excellent article-thank you.

Which is why we need to start drilling our shit now. Show OPEC that we're interested in taking care of ourselves and don't need them (which is BS, but they'll cave) and the prices will drop to the point of supporting gas prices back in the $2.00/gallon range.

The big thing is getting the petroleum companies to build more refineries - without more refineries, we can't process any more oil into gasoline than we do now, so even if the demand were to rise, we'd still be stuck with nowhere to go.

Not to mention, while we're drilling our own stuff and watching OPEC drop the prices, we still work on replacement energy sources and eventually ween off oil as our main energy source. Then we'll have options, and the ragheads (along with Big Oil) can suck it.

(If Big Oil was smart, they'd invest some of that massive oil profit into some of the replacement energy sources and corner the market there, too...)

Eric for President!!!!

He'd get my vote.

Unfortunately Big Oil is NOT the problem.

Big Green is the problem. They've set so many bullshit laws that it is just about impossible to build new refineries in this country.

We are letting them destroy the country, frankly.

By all means, don't mess up the environment- -but let's be more rational with the laws.

I would love nothing more than for us to be able to tell the ragheads to stuff it, and watch them drop back into the level of "Civilization" they were at 100 years ago- shitting in caves.

I think we have found our Vice-President.

Nah, they'd run me off in short order, what with the kilt, the booze, coarse language, firearms, and fast women running about... to say nothing of the lack of political correctness in my persona.

I love animals. Not to the level of some of the more depraved or demented of our society, but I believe in the concept that says that, as the dominant species on the planet, it is beholden to us to protect all animals, great and small...

... TO A DEGREE. Drilling here will wipe out a herd of caribou? Well let's look into relocating them into another area, and let's make sure when we put this pipeline in that we don't leak the shit everywhere.

There's 2 Red-Cockaded Woodpeckers living somewhere in this 3 million square acres of the forest... maybe? Fuck 'em. If we see them, we'll relocate them-- but yaknow, with all the noise of construction, I can't help but think they'll hightail it the hell out of there, IF we get close to 'em.

But when it comes to supporting the country at the present level of technology and civilization that we now enjoy-paved roads, indoor plumbing, electric lights, the whole glorious mess- I will personally drill through the head of a polar bear- with a hammer- to get to the oil. And then skin the bear, tan the hide and make a rug out of it for my office, and put his deboned and filleted carcass in my freezer. Bear's good eatin'. As Uncle Ted says, "Kill it 'n Grill it!" Might even save a bit of that fur to make a snazzy sporan. Great-granddad would approve

I couldn't agree more.

(do NOT get me started on this cockamaimee horseshit about trying to make Polar Bears an endangered species. It's in the numbers, folks. There's MORE of them now than there was (if I recall my numbers properly) 30 years ago.

They weren't endangered THEN....

There's MORE of them NOW...

WTF?? Why is this hard??