Oil Prices: A Correction is in the Cards

Predictions of soaring oil and gasoline prices fly in the face of the fundamentals -- oil stocks are flush and fuel demand is ebbing.

By Jim Ostroff, Associate Editor, The Kiplinger Letter

March 3, 2008

This large run-up in oil prices will be difficult to sustain. Though the weak U.S. dollar is encouraging traders to buy oil and other commodities as a hedge, ample oil supplies and weak economic growth presage a price correction in coming weeks.

"Oil prices have been gyrating violently ... but [economic fundamentals] make it likely oil is set to fall below $85 and keep going to the $70s by June," says John Kilduff, a senior vice president with MFGlobal, a commodities trading firm. There are plenty of other, more dire, forecasts on oil, including some calling for oil to climb to $200 a barrel. But Kilduff believes lessening energy demand will dictate otherwise.

As for gasoline at the pump, we expect the national average price to decrease by about 10% by June from the same date a year ago.

Note that there’s currently a surplus of oil worldwide: It’ll reach 1.5 million barrels a day this spring, a significant jump over last spring’s 500,000 barrels a day. The surplus will cushion the market against supply disruption risks that have fed oil price escalation since 2004 by emboldening traders who bid up prices knowing prices wouldn’t slide for long.

The Organization of the Petroleum Exporting Countries (OPEC) will have a role in moderating oil prices. When ministers of the OPEC meet this week in Vienna, Austria, they’ll brush off calls to slash oil export quotas made by the usual suspects, Iran and Venezuela.

Why? The cartel’s oil ministers know that the sluggish economies in the U.S., Canada and other nations will slice motor fuel demand. They fret that $100-plus oil prices in perpetuity will give even greater vigor to the development of ethanol- and electric-powered cars and trucks, which would permanently reduce demand for oil.

In fact, the current economic slowdown in the U.S. already has knocked down demand for gasoline by more than 1% from a year ago -- the U.S. consumes around a quarter of the world’s oil. The U.S. is burning about 6% less distillates -- mainly diesel fuel, says Timothy Evans, an energy analyst at Citigroup Global Markets.

Fuel usage will fall further as consumers tighten the reins on spending, take fewer car trips, step up use of public transportation and vacation closer to home this year in response to tough economic times. OPEC knows that cutting oil exports to keep prices north of $100 a barrel "means consumer demand for gasoline won’t just be dead in the water by summer, but so too will oil usage," says Evans.

Barring a major disruption, of course, we expect gasoline prices to average around $2.85 per gallon this year, up a nickel or so from last year. For diesel fuel, expect to pay an average of $2.95 per gallon, up a dime.

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