Energy Prices Are Headed Lower -- Really

Amid the wild volatility, a better supply and demand dynamic is developing. But even after prices fall, conservation will endure.

By Jim Ostroff, Associate Editor, The Kiplinger Letter

June 11, 2008

Oil prices continue to gyrate, but the longer-term trend is gradually down as the commodities bubble slowly deflates. Volatility will remain high. Still, look for oil prices to fall about 30% to around $100 per barrel by the end of the year.

And look for gasoline to dip to $3.45 a gallon by December, down about 14% from this month's high. Why? Demand is falling, the same way it did in 1979 and 1980, when pain at the pump slashed U.S. gas use by 5% and 6%, respectively.

Miles traveled in the U.S. plunged by 4.3% in March alone. In the last week of May, the peak summer driving season's kick off, gasoline purchases slid 3.9% from the same week a year ago. In cities and regions from New York to Los Angeles, where pump prices are well north of the current $4-a-gallon national average, gas retailers are reporting a 5% to 10% drop in fuel purchases, says John Kilduff, a senior vice president with MF Global, a commodities trading firm.

Consumer habits are changing, too. The biggest switch is to smaller cars and away from large SUVs and pickup trucks. Four-cylinder engines made up 45% of May sales, up from 30% in May 2005. Energy is also a more important factor to many consumers when it comes to purchases of home appliances.

The U.S. isn't alone in reducing energy consumption or changing habits. When government subsidies in many Asian nations disappear by year's end, demand will slacken. China, which has been stockpiling supplies for the coming Olympics, will likely shift gears and cut back on its energy purchases by August.

A strengthening dollar will help although its moves will be volatile, too. But the buck's gradual recovery will lessen the need for oil producers to keep prices high on crude, their primary greenback-denominated export.

The supply situation is improving, too. "The Saudis haven't trumpeted the news, but their oil exports are up by 300,000 barrels a day and U.S. refineries are operating at about 88% of capacity, helping to increase fuel supplies," says Kilduff. That's up from nearly 80% a few months ago. Modest production growth, mostly from Russia, is another positive.

The upshot: a better supply and demand dynamic, as oil supplies move from a deficit of 900,000 barrels a day that had to be made up by dipping into reserves, to a global cushion in production capacity of 600,000 barrels a day.

But demand destruction and increased supplies tell only half the story. Close to 50% of the price drop will come from speculative froth subsiding. The rush of money into commodity investments has slowed. Big bets on oil will ebb amid U.S. regulatory probes of speculative trading and more clear-cut evidence of plunging demand.

Prices likely will zig and zag wildly in coming months, until traders endure enough pain to persuade them that the sky is not the limit for oil prices. "Despite some investment banks [such as Lehman Brothers] warning oil will top $150 a barrel, the bull oil market may well be in its final stage before a price blow-off that could take prices below $100, [perhaps] down to $85," says Phil Flynn, a vice president with Alaron Trading, a commodities trading firm.

Yet few are forecasting any long-term, lasting collapse in prices, the kind of decades-long trough that followed spikes in 1979 and 1980. Supplies just can't be increased as much or as quickly as they were back then. And wringing out major energy inefficiencies is a lot tougher today. There was plenty of low-hanging fruit to pick a couple of decades ago. That's no longer the case.

But pricking the commodities bubble will sure feel good. To the relief of central bankers worldwide, it'll reduce inflationary pressures, giving consumers and businesses a break and encourage spending and investing. That's just what the ailing economy needs.

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