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JakilaTheHun (99.93)

The Fear Bubble in Oil

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March 02, 2011 – Comments (4) | RELATED TICKERS: USO , SU , OIL

Oil price predictions are getting outlandish again.  A Martin Hutchinson article today talks about how a Middle East meltdown could mean oil prices over $300/barrel.  Are you f@#$ing kidding me?!!

The "Fear Bubble", as I like to call it, might eventually drive oil up to $120/barrel; or even $150/barrel, but the idea that it would drive it up to $300/barrel is extremely far-fetched for several reasons:

(1) A massive amount of untapped deposits in North America (and across the world) would become extremely profitable over $130/barrel.  

(2) Given both the US's heavy dependence on oil and China's increasing dependence on oil, Hutchinson is dramatically underestimating demand destruction.  It's more likely that a rise to $160/barrel would push us back into recession, therefore, causing oil prices to fall again. 

(3) In some odd event that $160+/barrel oil didn't push us into recession, it would nevertheless become more economically efficient to restructure our economy away from oil.  At prices over $200/barrel, we wouldn't even need government subsidies!  The free market would try anything and everything to replace oil!  This means that our overall dependence on oil would be reduced.  While it might not happen over night, it would happen much more quickly than some might believe. 

(4) Hutchinson uses an overly simplistic model that does not factor in how the price elasticity of demand would shift towards a much more elastic demand at higher price levels.  Oil is only inelastic at the current levels because the substitutes are more expensive and because our infrastructure is currently designed under this assumption.  Destroy this paradigm and oil suddenly looks much easier to substitute for.

 

Overall, I think Hutchinson and others are ignoring the economic context here.  It's not as if there aren't numerous options to diversify our economy away from oil.  It's merely that there's been little economic incentive to do so, given low oil prices.  If oil prices skyrocket, suddenly, the incentives dramatically increase. 

 

4 Comments – Post Your Own

#1) On March 02, 2011 at 3:33 PM, Pennyperson (< 20) wrote:

Diversify our economy away from oil - Amen- if we don't - I'm might start reading Alstry's blogs and that's scary.

High gas will drive the economic recovery to a halt.

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#2) On March 02, 2011 at 4:12 PM, leohaas (91.68) wrote:

The error in the article is in the calculation based on the price elasticity for demand. It is calculated for 70% and then extrapolated for almost 3 times that. In other words: assumed to be linear. That clearly is not the case.

However, when it comes to developing alternatives (including exploring many of the untapped reserves in North America), we are talking years, perhaps even decades before they are available to offset dropped supply. So in the short term, we can expect a significant spike. I am speculating that that will happen.

Disclosure: long USO at the time of writing.

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#3) On March 02, 2011 at 5:59 PM, JakilaTheHun (99.93) wrote:

Leohaas,

I generally agree, but at $300/barrel, I'd wager to guess that you'd see very dramatic efforts to reduce oil consumption in a relatively short time frame (1-2 years).  More cities would shift to street cars, more goods would be shipped via rail, more nuclear power plants would be built, many bus operators would start shifting to natural gas, etc., etc., etc. 

You're definitely right on the general point, but I think that's more true with oil around $150/barrel or even $200/barrel --- at $300/barrel, it just makes economic sense to immediately shift away from oil. 

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#4) On March 03, 2011 at 12:13 AM, russiangambit (29.90) wrote:

> In some odd event that $160+/barrel oil didn't push us into recession, it would nevertheless become more economically efficient to restructure our economy away from oil.  At prices over $200/barrel, we wouldn't even need government subsidies!  The free market would try anything and everything to replace oil!  This means that our overall dependence on oil would be reduced. 

Well, it will definitely send US economy in tailspin short term. But long term it will probably mean I will finally be able to see the road and not just towering trucks all around driven by individuals of questionble sobriety. In Houston everybody drives a tank. Ford 150 is especilly popular followed by subarban. I noticed a lot of new shiny Ford trucks appearing last year when oil fell through the floor. It took people just about 3 months to forget how they were lining up for Pruises. 

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