Rock-Bottom Energy Prices Won't Last

Demand will rise when recovery begins, pushing oil and gas prices higher.

By Jim Ostroff, Associate Editor, The Kiplinger Letter

January 21, 2009

Gas pump prices are unlikely to be this cheap again for years to come. They will be heading higher by early March. But the increases will be modest with no repeat of 2008's eye-popping hikes from the year's first half that left many motorists outraged. Gasoline prices soared 40% to more than $4.11 for a gallon of regular unleaded on average nationwide in July and just shy of $5 a gallon in many metropolitan areas.

We see gasoline prices bottoming out sometime in February at about $1.60 a gallon on average nationwide. Then as usage ticks up seasonally, they'll probably climb a few cents each week or so through Memorial Day weekend, cresting near $2 a gallon. Barring a massive oil supply disruption, gas prices should in fact average around $2 a gallon for the year. That would be the lowest since 2004, when motorists paid $1.85 on average for the year. Last year's at-the-pump tab averaged a record $3.27 a gallon.

The difference between last year and this one is the recession's impact, which will weigh heavily on oil prices, trimming prospects for big price hikes at the gas pump. "Nothing depresses energy prices more than a dismal employment outlook that curbs fuel usage, and the ongoing job loss numbers are mind boggling," says John Kilduff, a senior vice president with MFGlobal, a commodities trading firm.

Oil traders remain glum, expecting perhaps a marginal boost in oil demand on the heels of a nearly 6% plunge in 2008, the first annual decline in nearly 20 years. With speculators all but sidelined, oil prices should remain in the neighborhood of $40 to $60 a barrel this year, despite production and export cuts by the Organization of the Petroleum Exporting Countries.

It will take a while longer for diesel prices to reverse course. They should slide 20¢ to $2.25 a gallon through spring before heading toward $3 a gallon in the summer. Don't count on diesel fuel reverting to its decades-long pattern of being substantially lower cost than gasoline. Environmental regulations adopted by the U.S. and Europe a few years ago make it more costly to refine the fuel. China is playing a part, too. Its industry gulps diesel to power portable electric generators, a proxy for inadequate grid power in many rural areas. China's economy is slowing, but it will remain one of Europe's largest customers for diesel fuel, competing directly with U.S. refiners.

Lower winter heating bills are in the cards, too. Retail heating oil prices should decline from about $2.25 a gallon to $2 by spring and average $2.30 for the year. That will be down nearly one-third from 2008's $3.30 average price. Natural gas prices are set to swoon 40% by spring to $3 per million British thermal units (MMBtu). The fuel is being hammered by recession-dented industrial demand and huge supplies, as new natural gas projects planned years ago have started producing. Prices will average $6 per MMBtu this year, down 30% from 2008.

Across-the-board bargain prices won't persist over the long haul. Tight oil supplies that have increased oil and motor fuels prices since 2004 are masked now by the recession-induced demand drop. Supply adequacy will be a potentially bigger headache when recovery hits its stride. "At the first signs of a real and sustained improvement in the economic outlook, oil prices should rebound and [there will be] a run-up to $70-a-barrel oil, and that will happen quickly," says Kilduff.

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