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Trends Affecting Oil Price

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$100 oil could seem like a bargain if economic growth continues but supply of oil is constrained.

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As we began 2007, crude oil was hovering around $60 a barrel. Today the price is closer to $90, and came within whiskers of $100 less than a month ago. So what's driving crude oil to record prices? It's easy to blame "big oil" or hedge funds and speculators for the rising price of energy, but to do so would ignore many of the fundamental changes in our world. To understand these changes we need to recognize the attributes of oil that make it different from other commodities.

Let's take a look another commodity that has seen a significant rise in price over the past few years: copper. Copper is one of those commodities the world needs more of to expand. For instance, a new 2,200 square foot house requires about 450 pounds of copper. Once the house is completed, no additional copper is required. If there is not another house to build, copper demand will go down. Copper is a commodity that requires additional economic growth to maintain demand.

Oil on the other hand is different. Much of the world's population is now making enough money to purchase a first car. Each of these cars requires gasoline to operate which increases overall demand for oil. If economic growth were to stagnate, these cars would still require the same amount of gasoline even if no new cars were built. Demand for oil will not come down unless there is an economic contraction. Could higher oil prices cause an economic contraction? Absolutely. But this brings us to another interesting fact: not all countries require their citizens to pay market prices for oil (and gasoline).

Price controls in many oil exporting countries contribute to higher demand because citizens do not have to pay market prices for petroleum-based product. Several countries set gasoline prices at ess than 50 cents a gallon, which has allowed demand to spike. $100 oil does not affect folks living in countries like Iran, Venezuela, and Saudi Arabia. Even China (to a lesser extent) uses price controls for petroleum-based products. At some point, higher energy prices will curb demand and economic growth, but we're not there yet. There aren't any price controls in the United States and demand for crude oil and petroleum-based products are at all-time highs.

One of the most important long-term drivers of oil demand comes from the collapse of communism. For decades, communist nations like the Soviet Union and China resisted capitalism and the western world and their economies suffered for it. These economies have a lot of catching up to do as a result of years of underinvestment. This pent-up demand is a long-term phenomenon. We are in the midst of a massive global infrastructure build-out that could last for years. Everything from roads and highways to power plants and buildings require energy. As the rest of the world continues to chip away at the wealth gap with the United States, energy demand will continue to ramp. The United States now has competition for the precious energy required to grow world economies.

Another important driver of energy demand comes from the often overlooked global change in dietary trends. As global living standards increase, people want not just more food, but better food. While much of the energy required to harvest agriculture product comes from natural gas (in the production of fertilizer), oil also plays a significant role. Most farm equipment is run on oil-based products, as are the planes, trains and trucks used to transport agricultural product to consumers. The average distance the typical American meal travels from "farm to fork" is about 1,500 miles. It is estimated that about 400 gallons of oil equivalents are expended annually to feed each American. As per capita income continues to trend up in developing countries, food demand will continue to increase adding incremental energy demand.

While there are many additional drivers of oil demand, there are other factors at work putting upward pressure on crude oil. Rising crude prices have allowed many energy companies to become more profitable than any time in history. Unfortunately, most of the crude oil supply comes from countries in the world outside the United States. These oil exporting countries want their cut too.

Higher energy taxation and/or outright nationalization of energy assets will continue to drive prices higher. At first, it was countries like Venezuela and Russia that forced out some of the world's largest energy companies that had invested billions to develop energy resources. For a while, these countries will benefit from the investment made by western oil companies in their countries. Over time, history has proven that it takes not only capital, but skilled labor to maintain and develop natural resources properly. Without proper investment, oil production will eventually decline in many of these countries.

The supply side of the energy equation has been the subject of much debate in the past few years. The concept of "peak oil" is gaining traction with many savvy investors. The argument is based on the same logic Dr. Hubbert used to predict peak oil in the United States almost 15 years before it actually occurred. Eventually, the world will reach a point of maximum oil production. Whether that number is 85 million barrels per day or 90 million barrels per day is irrelevant, it's coming. Once demand outstrips supply by even a small percentage, expect to see an even large surge in the price of oil. $100 oil could seem like a bargain if economic growth continues but supply of oil is constrained.
No positions in stocks mentioned.

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