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By Knight Kiplinger

The Kiplinger Washington Editors

May 16, 2008

Overall prices will rise 4% this year -- on a par with last year -- but inflation clearly feels much worse for businesses and households struggling to pay bills. This week's Kiplinger Letter analyzes the various pressures impacting prices and forecasts when inflation will ease.

ALSO INSIDE THIS ISSUE: The Dollar vs. Euro, Investing in Brazil, Mexican Drug Violence, Retail Trends, Fingerprinting Foreigners, Hotel Rates, Steel Pennies, Climate Change and Election 2008.

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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

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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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POSTED BY: Corbin (March 03, 2008 10:22 AM)
Oil producing nations know that it is a losing prospect to let prices of gasoline spiral out of control for too long. After all, they wouldn't want the rest of us to maintain a sustained effort at riding our oil addiction. But at the same time, there is no reason to assume that they want prices to remain too low either. Undoubtedly their strategy is to bilk the world for as much money as possible for as long as possible. The only way to beat them over the long-haul is to rigorously pursue oil alternatives regardless of the price of oil per barrel. In light of the associated, environmental issues, this only makes sense. In the meantime, we should drive less and ride our bicycles more!

POSTED BY: MAF (March 03, 2008 11:12 AM)
I don't know how Jim calculates the 1.5 m b/day oil production surplus. According to the Feb 13,08 IEA Oil Market report, January world production equalled 87.2 m b/day while average demand in 2008 is expected to be 87.6 m b/day. In fact, their estimate for Jan-Mar, 08 consumption is 88 m b/day and OECD oil stocks are at the lowest point since Dec, 2004. And China shows no signs of slowing. Every 10 % of GDP growth in China equals about 8 % of growth in oil demand, according to energy economists. So how does Jim predict a surplus when the 87.2 m b/day of production is by far the highest that the world has ever produced by about 700,000 b/day ?

POSTED BY: AAK (March 03, 2008 05:52 PM)
There was a Tech Bubble in 2000, then Housing Bubble in 2005, Now it is Energy/commodity Bubble 2008. All this Bubbles are created by Financial Institutions, they no longer are doing business based on Fundamentals, their aim is to make short term gain (by speculation). In all 3 bubbles common man is effected first and then them self � Massive write downs. Now they are playing the game of Hedging. Some one of Greenspan stature needs to burst the bubble. Don�t know when that bubble is going to burst.

POSTED BY: Jokosan (March 04, 2008 12:56 PM)
When will these selfish and self-centered US politicians stop this nonsense of refusing to drill for known massive quantities of oil on our own soil (like that frozen swamp next to Prudhoe bay in Alaska) called ANWR and allow the oil companies to do their thing so they can address the supply issue instead of focusing on demand (which will remain high, by the way) The way I see it, It is politicians like Obama, Clinton, and yes, McCain that voted AGAINST drilling in ANWR. They are clearly partly to blame for high gas prices....no doubt about it.

POSTED BY: Jim (March 05, 2008 07:33 PM)
My suggestion is that all that read this article do a little research on "peak oil"...this article is all about demand with little real knowledge of the actual supplies...there is a lot of posturing on "reserves" but oil is not an unlimited resource and we are at or over the top of the supply bell curve... $100 plus oil is here to stay...and don't be surprised to see it hit 120 this year...

POSTED BY: Jim Ostroff (March 06, 2008 06:22 PM)
The IEA has reduced its world oil demand estimate several times since fall 2007. During the past month U.S oil usage has declined nearly 4% and is easing elsewhere. Continuing economic weakening and high fuel prices will reduce oil demand further. The "oil supply cushion" will increase due to lower fuels usage. No question that the world will reach "peak oil," as Kiplinger wrote about extensively in 2005. It may occur within 5 years--or 50; perhaps in the 22nd century. Both elevated fuel prices and the development of alternative fuels will lengthen the lifespan of this finite resource.

POSTED BY: bob (March 08, 2008 10:34 AM)
your column makes sense... but then when do oil prices follow common sense..oil prices are determined by giant oil companies. as you know there are large oil companies or price leaders that determine what the price of a gallon of gas is going to be. the demand for gas will stay pretty much where it has been.. the thoughts of people using less gas is just not possible and i think we all know that...

POSTED BY: Ryan (March 10, 2008 04:41 PM)
Oil is the next bubble, after a year of $3 per gallon, people have sold the suv and trucks, and are cutting down. The people I communicate with on a daily basis have all changed their driving habits and/or purchased more efficient vehicles.

POSTED BY: Jim Ostroff (March 10, 2008 06:54 PM)
Oil companies do not set prices for crude oil. Traders do. Consider: Oil supplies and demand are not very much different now than they were a year ago. Oil prices are 75% higher today. The increase is virtually all trader driven. Motor fuel usage has been sliding, mainly due to the softening economy.

POSTED BY: Greg (March 11, 2008 10:11 AM)
TOO MUCH MONEY IN THE COMMODITIES MARKET...THE MARKET WILL SOP IT UP! FOR THE GOOD OF THE COUNTRY YOU TRADERS FIND SOMETHING ELSE TO INVEST IN....LIKE OIL WELLS! NOT FUTURES! GREED QUADRUPLES EVERYBODY'S ENERGY COSTS ... AND SINKS THE COUNTRY!

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