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Here we go again. It was just three years ago that oil prices spiked and commentators all over started making outrageous predictions of $200 oil. In the past few weeks, we’ve started seeing these predictions pop up again. Financial writer Martin Hutchison even went a step beyond that, arguing that oil was destined to hit $300/barrel.

Many people enjoy making sensationalistic statements about the price of oil, but I am here to say, it’s not going to $300/barrel. It’s not even going to $200/barrel any time in the next few years. I’ll even go a step further and say that while it’s possible that oil could hit $150/barrel, it won’t stay there for very long, if it does.

Why am I so confident making these predictions?

Simple economics.

The Economics of $300 Oil

The reason why $300 oil is such a nonsensical result is that the supply and demand dynamics would radically change at the price. In his article, Martin Hutchinson extrapolates demand for oil at $300/barrel using its current price elasticity of demand. For those unversed in economics, the price elasticity of demand will tell you how much demand will decrease as the price rises. Highly elastic demand implies that small price increases could dramatically reduce demand. Highly inelastic demand implies that large price increases would only reduce demand by a little bit.

Oil is considered relatively price inelastic. In America, we will drive to work every morning whether oil costs $2/gallon or $3.50/gallon. Our overall consumption of oil will not decrease that much with price rises. This is why oil can spike and it sends everyone into a panic.

Martin Hutchinson uses the current price elasticity of demand to estimate a future equilibrium price based on Middle East supply disruption and panic. The only problem with this methodology is that the price inelasticity of demand would likely radically shift for oil once it hits a certain level. Here’s the issue: While there are no easy substitutes for oil at $100/barrel, there are a lot of substitutes over $200/barrel. Moreover, many technologies that reduce oil consumption became vastly more economically appealing at $200. While I can’t claim to know the exact level where the shift becomes most profound, I feel pretty safe in saying that it is well below $300/barrel.

Hutchinson ignores the fact that oil would become much more price elastic at higher price levels. What’s more, supply would also increase at those levels.

So what would happen at $300/barrel?

All of the things below:

(1) Oil supplies. Many on-shore North American oil reserves would become economically viable and extremely profitable, thereby, increasing supply of oil significantly. This would tend to pull the price downward.

(2) Natural gas powered vehicles (NGPVs). Natural gas would become vastly more economical if oil tipped $300/barrel. Some mass transit systems already use NGPVs. While it’s questionable whether automobile-makers would shift over to NGPVs at $300 oil, we can at least say that mass transit bus systems in America would become much more interested in converting. This would decrease demand for oil significantly.

(3) Mass transit. Mass transit in America is woefully underdeveloped, but once oil hit $300, you better believe that people would be crowding onto trains and buses to get to work. It’s likely that we would finally hit a tipping point where voters would become angry at the lack of mass transit, which would then cause an increase in supply on that front. An increase in mass transit would mean a decreased demand for oil.

(4) Trucking. As oil hit $300, the one industry that would suffer the most is the trucking industry, which would become increasingly uneconomical versus rail. With fewer truckers on the road, oil demand decreases radically.

(5) Nuclear/alternative energy. Oil at $300 would even impact our electric power significantly. It would have an impact on coal prices at the very least, thereby making alternative fuel sources such as wind, solar and geothermal seem much more economical. Moreover, nuclear power would look even more attractive. It’s unclear how radically this would change demand, but at the very least, it would decrease demand for oil.

(6) Hybrid and electric cars. Let’s take a look at this from the consumer front. If you are buying a car and you believe oil is going to stay over $200 per barrel for a significant period of time that changes the economics behind your own decision. The result is that you would find it much cheaper to purchase a car with great fuel mileage (such as the Toyota (NYSE:TM) Prius), or even an electric car (such as the Nissan (OTCPK:NSANY) Leaf). This would also decrease demand for oil significantly.

(7) Demand destruction. Finally, if all that weren’t enough, there’s the whole “dismal science” part of this. Oil at $300 would likely push America back into recession. Recession would significantly decrease demand for oil. In other words, the economy can’t even support $300 oil to begin with.

While the oil price sensationalists might counter that they were only suggesting that oil would briefly spike above those price levels, even those predictions seem very unlikely given the massive changes in economics with $200-plus oil.

My basic overarching theme here is that while the U.S. economy is “fueled by oil," so to speak, things would change much more quickly than most think at $200-$300 oil. Almost all new purchases would push toward minimizing oil usage, even if it meant higher up-front costs. Radical changes in the U.S. economy could occur within 2-3 years at such exorbitant price levels. This is why the Saudis would much prefer to increase oil supply right now, rather than allow a scenario where Americans find it more economical to change their habits. Oil at $150-plus isn’t good for oil producing nations in the long-run.

To further illustrate my point on the consumer front, let’s look at an easy example: purchasing a hybrid car versus a regular car.

The Economics of a Hybrid

Hybrids tend to cost more than traditional vehicles. The best known hybrid is the Toyota Prius, which is priced around $23,000. For a more accurate comparison, let’s stay within the Toyota brand and compare the Prius with a Corolla and a 4Runner SUV. The Corolla is priced around $15,600. The 4Runner clocks in at $29,700. Since the 4Runner is already less economical from the get-go, I mostly provide it for purposes of illustration.

One final note: I would also like to compare all the aforementioned vehicles with an electric car, such as the Nissan Leaf. Unfortunately, that would make my model much more complicated and quite frankly, I am not sure how to calculate the amount of electrical power the Leaf would consume or the probable rates for that power.

So with that, we’ll simply compare the Prius, the Corolla and the 4Runner.

  • MPG = miles per gallon
  • MPW = miles per week
  • GPW = gallons per week

The chart above compares the three models. I estimated miles per gallon at 48, 30 and 20, respectively. In my “previous life," I drove, on average, 300 miles per week; which is about 15,000 miles per year. I’ll use this as my baseline assumption for usage. The last column in the chart above is “Gallons per Week," so I estimate that the Prius would require 6.25 gallons per week, while the Corolla would require 10 gallons per week for my weekly driving needs.

The next chart shows “Gas Expense per Week” for the three cars under our standard assumptions:

Now, let’s turn the above chart into “Gas Expense per Year” for more clarity:

Admittedly, these charts contain a lot of data, so I wanted to make it simpler to see the “costs savings” associated with the Prius versus the other alternatives. The chart below does just that:

Now, just to show how much of a finance nerd I am, let’s determine the present value of the cost savings over the lifetime of the car. This will make it easier to evaluate the economic value of each car, given the gas cost savings.

For the next two charts, I am assuming a useful life of 12 years for all the cars.

I’m not sure what the appropriate discount rate for an average consumer would be. It would be the “opportunity cost” of giving up more money to purchase the Prius, but we’d have to determine the consumers’ best alternative course of action.

For the first example, I decided to use an 8% discount rate, which I believe is actually way too high for most consumers, but since this is the more conservative assumption, we’ll start with it.

More realistically, the consumer could invest the money in either stocks or bonds. Stocks return about 6.25% on average over the past 50 years. And 10-year bonds are currently returning only about 3.5%. I decided to use the 10-yr bond and increase the rate to 4%. So the second chart uses a 4% discount rate. Here are the results:

Click to enlarge

Now, let’s analyze the numbers.

Economic Analysis of Auto Purchases

From a consumer perspective, if oil were to top $200/barrel, gas prices would probably be around $6+/gallon. Even with the higher 8% discount rate, one would achieve $8,800 in cost savings on gasoline with the Prius versus the Corolla. The Prius has an up-front cost of about $7,500 more than the Corolla, so once you factor in the $8,800 cost savings, the Prius is actually $1,300 cheaper.

If we go to the lower 4% discount rate, that gas cost savings associated with the Prius jumps to $11,000. The Prius would then be $3,500 cheaper than the Corolla.

At $300 oil, gasoline prices would rise to around $9.50/gallon. At that price, the gas cost savings from the Prius should be in the $14,000 – $17,500 range. No one in their right mind would buy a Corolla at that level, when they could buy a Prius and save somewhere between $6,000 – $9,500 over the life of the car.

In either of the scenarios above, it’s likely that hybrid sales would skyrocket and sales of non-hybrid cars would drop significantly. Consumers often prefer hybrids even without the costs savings, because they place a value on "harming the environment less." Once the raw economics make hybrids cheaper, however, even the non-environmentalists are going to want to buy a hybrid. What this would mean is that U.S. gasoline consumption would start to decline significantly within a few years.

Ironically, this might undermine the economic premise behind buying a hybrid, but my basic conclusion here is that oil won’t reach $200/barrel to begin with, because the economics of hybrid cars become more attractive even when oil is around $150/barrel. Due to these changing economics, oil would have a difficult time pushing that too far above $150/barrel for any significant period of time.

Remember, that this is only one example. I gave numerous other ways that the market would shift with significantly higher oil prices, but this is one example where you can see the numbers for yourself. Also let’s not forget that I did not factor in electric cars since I was not sure how to calculate the costs, but presumably, the cost savings of the electric car would be even greater than the hybrid for some people, further reducing oil demand.

My basic point here is that this is not the 1970s. The U.S. economy is already set up so that there are many substitute products out there that eliminate the need for oil or reduce its usage. At $100/barrel, these substitutes are only marginally economical. At $150-$200/barrel, these substitutes start looking considerably more attractive. This is why oil will have a difficult time pushing above $150/barrel and even if it goes there, it won’t stay very long.

My best estimate of a reasonable trading range for oil is between $75/barrel and $120/barrel. Any time it pushes above $120/barrel, there will be significant downward pressures on the price.

How to Invest

So how do you play this from an investment perspective? With oil trading at $105/barrel right now, I would be reluctant to go long on oil. In fact, I have started exiting some of my positions, completely selling out of a long Suncor (NYSE:SU) position and exiting my Jan ’12 calls (which I bought during the BP (NYSE:BP) oil crisis).

What to buy is a more difficult proposition. I have initiated some long-dated calls on Delta Airlines (NYSE:DAL). This is partly speculative and partly based on views of DAL being a "turnaround" story.

Long-term, oil at $105 is not necessarily unsustainable; but I do think it’s overpriced and should retreat to around $90/barrel. Oil supply is already too high, so the fact that prices are rising with excess supply suggests that there will be downward pressures once the “fear premium” from the events in the Middle East subside.

I own a few oil and gas stocks, but continue to debate scaling back on those positions.

Disclosure: Long on a few oil and gas related stocks. I am long DAL, PXP and BP. Long on DAL call options.

Source: Why Oil Is Not Going to $200

Additional disclosure: I am long DAL, PXP, BP, and may own long positions or calls on a few other oil/gas related companies.