A Supply Side Problem: Oil's High Price is Here to Stay

While Wall Street has been concentrating recently on the demand side of oil leading to lower prices, the future conditions of oil prices have been and will be determined by supply side economics.

The fallacy is that a mild to moderate recession in the United States will lead to lower oil demand and thus a drop in oil prices. This is a short-term projection. Even with lower demand in the United States, the growing markets hungry for oil such as China and India will put constraints on supply in the future. Keep in mind that to a degree oil is inelastic. There is only so much lower demand that even a recession can bear. Companies still have to get their goods to their ports. People still have to go to work.

Even with new conservation, supply availability will lead to higher prices no matter what the demand may be. Why? Because many have looked at the demand for oil as if it was a discretionary product. Oil demand will reach a level where discretionary demand gets closer to zero, while the inelastic demand will continue to go up.

The infrastructure for oil is still intact for many years to come. While many talk about wind, solar, and better mileage cars, this infrastructure is many years away. The old paradigm will be with us for many years to come. We simply cannot lower the inelastic demand for oil with the turn of a switch. With supply constraints, oil prices will eventually go higher, yes even with a moderate US recession. Added to the argument is the geopolitical problems which may cause high disruptions in oil supply.

So what is the argument? The argument is that no matter the size of the US recession, no matter the short term infrastructure on conservation measures, no matter the lower discretionary demand for oil may be, the higher demand for the inelastic demand for oil, especially in the emerging economies, will lead to higher prices of oil. The high price of oil is here to stay.

 

Comments

[MiningOilGa...:]

Nice article.
High oil prices have become the norm as everyone has adjusted or is adjusting to cope with them. Usually it means less income to dispose on personal purchases. And there are too many people making profit off these high oil prices, there is no reason to drop oil prices now if people are still willing to buy it at such a high price.

2008 Aug 06 09:42 AM

[John Pseudonym:]

All of the "emerging economies" are building those economies based upon oil; that's a guaranteed long term bull market in oil.

There will be ups and downs, but the trend is up. Wait for the price to stabilize, read the charts and then get back in.

2008 Aug 06 10:06 AM

[Brian Pursley:]

What supply side problem? How is a trillion barrels a supply side problem? Hydrogen is the most common element in the universe and carbon is the fourth most common element in the universe.

2008 Aug 06 12:56 PM

[worthy:]

The two comments thus far are overly simplistic. The original article also has a flaw. The notion that a supply level of "x" will lead to inelastic pricing is valid. The problem is that we do not know at what supply level. We do not know the degree of demand destruction owing to the "flipside" of inelasticity, i.e. higher prices can reach levels that destroy demand to the degree that is presently immeasurable, because we have never been in a worldwide economic circumstance like we are now. Further, complementary fuels such as natural gas, coal, et al can "steal" some of that demand permanently. Add in solar, and wind generated electricity, and one is hard pressed to know what oil demand is going to look like over the next decade or two.
It is probably a safe bet that we won't see $50 per barrel anytime soon, but???, who thought the Nasdaq could fall 80% as it did from the years 2000-2002? As the old saw goes, "never say never"...

2008 Aug 06 12:56 PM

[worthy:]

To Brian Pursley,

Yes, and who knows, perhaps baked beans and kraut will power the proverbial Dutch windmills.

2008 Aug 06 01:00 PM

[knightowl1953:]

Thanks for the input. I appreciate the comments. Yes, a marginal supply price that is attainable is hard to predict. But the arguments for larger increases that are attainable present a better scnenario than to argue that prices are going to go down. The heart of my argument is that I believe we are just beginning to see the inelastic price for inelastic demand. It will only get worse, in my opinion, because the emerging nations will eventually grow larger than the demand of the US. Even with substitutes, such as coal, which on its own has gone much higher in price and has been able to maintain the levels, oil supply will eventually be lower than inelastic demand supporting much higher prices. And yes, with time, in my opinion at least 30 years, we may eventually see true substitutes for oil, such as hydrogen cars.

2008 Aug 06 03:03 PM

[john s. gordon:]

go light on the baked beans, methane is a strong greenhouse actor.
> jack

2008 Aug 07 08:31 AM

[CaptBob:]

You're -on the money--Worthy.
One other variable in the equation that bears mentioning is how oil is priced---in the almighty-(formerly) dollar.

With no change at all in supply demand with the continued devaluation of the dollar the "price" will continue to go up. However in other currencies which advance over the dollar those consumers of oil will get a break=fewer euros a barrel.

Then enters the supply/demand factor which in a declining production time frame will see prices increase for everyone, the levels each economy can bear will be the ultimate "stabilizer".

2008 Aug 07 11:11 AM

[Jimbo:]

Hydrogen as a transportation fuel presents severe technical and financial costs. It may happen but will take many years. I don't know where the "trillions" of barrels of oil are located but future oil will be difficult and costly to extract and this will guarantee the cost of oil. Any demand destruction in the U.S. will only make more petrol available for "Chindia". The "Chindians" have plenty of U.S. Dollars to pay for it too.

2008 Aug 07 11:50 AM

[Kunst:]

Brian Pursley, wandering in the desert. So much sand...

2008 Aug 10 02:35 AM