Back on June 23, I wrote a piece entitled “Why is Crude Oil (and gasoline) so expensive?” Since then, I’ve received quite a few emalis and comments to that piece - many of which essentially chastising me for not adopting the “drill here, drill now” framework as being the main lynchpin to solving US oil crisis and high gas prices.

Well - the fact of the matter is - the drop in prices can be better explained by the factors I identified than a statement by the President to remove the ban on off-shore drilling, or the current political storm in the House about getting the Speaker to allow a vote on drilling.

Put simply, supplies world wide have remained essentially constant (there has not been a change or increase in supply) - but US demand is falling and the ability to take up the slack demand of countries like India and China is temporarily maxed out; the US dollar is stabilizing, brought about by a belief that the Federal Reserve will have to raise short term interest rates, lessened concerns about a US recession (which would place pressure on the Fed to lower interest rates, even with inflationary pressures), increased concerned about US inflation rates (even with energy removed from the calculus), and that the United States is about to dramatically halt its borrowing because of the costs of issuing new debt; political instability has become less of a variable as it now appears a major conflict in an oil producing zone seems less likely; and finally, price speculation has been accelorating this decline because they are primarily attune to US economic factors, and thus, have been withdrawing money from the oil sector to put it into other investment activities that look more lucrative for the long term.

However, I believe all of this is only temporary in the long-term. In the short term, however, prices may drop considerably.  How low will gasoline go? I don’t know. I felt that gasoline would peak at about 4.15 a gallon for regular - and it did nearly that, topping out at 4.12 I believe. I now believe that gasoline will fall to as low perhaps as 3.30 a gallon, through the winter driving season in the United States. I would expect to see gas fall to about 3.50 a gallon for regular unleaded and oil remain close to or at about $100 a gallon (trading in the $90-110 range). The current forecast is for there to be ample supply of oil in the world market. I also expect OPEC won’t change policies in production ahead of the US elections. Saudi Arabia - the largest OPEC producer - was battered pretty hard politically for looking like it was profiting from the pain of US consumers. I think it will wait until after the US elections to gauge the political environment before adopting a change in production policy. Thus, oil output should remain globally pretty high (and stable) for the next several months. This means that the US and other countries will get an opportunity to develop oil inventories and that will also keep the prices lower.

The main reason why oil will remain at $100 a gallon will be the value of the dollar and the US economy. If the US economy improves in the first half of 2009, we could see prices drop rather quickly - perhaps as low as $60 a barrel again - if the US were to dramatically experience rocketing growth and the US dollar shoot back up to 2004 values. I don’t think that is going to happen, but, it illustrates would could happen.

The long-term, however, is less favorable. OPEC will eventually cut back production and prices will begin to rise. Moreover, India and China will increase their demand over time. Combine these factors with what is likely to be a tepid growth rate in the US, continuing credit problems in world markets, and an expansion of the credit collapse to hit Europe and Asia countries hard, and oil is under considerable pressures to stay at or above $100 a barrel.

There are some other factors that people need to also realize. First, the ability to refine oil into other products is probably going to be static FOREVER. Before you say that’s impossible - just follow the logic for am moment. In order to justify the investment of a refinery, the oil company has to be able to demonstrate that it can make that refinery profitable for a long enough period of time that the returns are worth the investment. For oil refineries, that can mean a time horizon of 30 to 40 years. Considering it takes several years to build the refinery, build the infrastructure to the refinery, and then begin distribution of the refined products, the lag time may be 35-45 years. That means essentially it takes a generation to get the benefits of the refinery where its operating costs are reflected only in the marginal costs of operation. Put simply - we may not have that much oil left such that we will need the excess capacity to refine compared to now.

For example, places like Prudhoe Bay, have seen their refining pumping drop from 1.6 million barrels a day at its height in 1998 to 400,000 (roughly 100,000 barrels a day now as a result of a pipeline problem, but it could be pumping no more than 400,000 barrels a day). If we open places like ANWR, we can increase that amount perhaps back up to 1998 levels for another 10-15 years.

But, the reality is, in terms of refining ability, it is hard to justify a new refinery for Prudhoe Bay’s output, if by opening new wellheads you only bring it back to the capacity you had in 1998. Further, in terms of crude refining capacity, in 1998, the US could refine about 15M barrels a day. Now the US can refine about 17M barrels a day. That is an increase of about 14% in the last 20 years. It is hard to imagine that with declining utilization (93% in 1998 to 88% today) that building new refining capacity is in the long-term interest of oil companies.

Which is why even though their coffers are stuffed with cash - none of it is going into building new refining capacity. Much of the money spend on refineries is in modernization, repair, and expansion. I’m not aware of any new refining plants.

The second thing people may need to come to terms with is the idea that we may be at peak oil. This is a concept I’ve resisted for some time - but I’m now starting to rethink. While ANWR, Bakken fields, etc., are things we should be tapping, the reality is, oil may be in (to quote the Vice President) “it’s final deathrows.” The long-slide from peak oil may take 50-100 years, but it is likely that we have seen the end of large new easily pumped fields. While there can always be technological breakthroughs, and incredible new finds, the reality is, we can really only get oil levels back up to 1988 levels perhaps, through drilling.

That means of course we should drill, and drill now, to bring that oil online to provide the US more time to develop alternatives and to keep our enemies/adversaries from tapping those reserves (and our cash). But it also means in the long-term, oil-as-usual isn’t a viable solution.

I am not as pessimistic as many that the collapse of oil will mean the collapse of civilized society. However, whether peak oil happened in 1980 (as some claim), is happening now (as many seem to think), or may happen in the near future (as I think), the reality is - we need to understand that as a finite resource, oil is being pumped out of the ground at a rate faster than it ever has been, and we’re going to eventually run out.

On the other hand, I could be entirely wrong. Some people are very optimistic: Abdullah S. Jum’ah, President, Director and CEO of Aramco states that the world has adequate reserves of conventional and non-conventional oil sources that will last for more than a century.As recently as 2008 he pronounced “We have grossly underestimated mankind’s ability to find new reserves of petroleum, as well as our capacity to raise recovery rates and tap fields once thought inaccessible or impossible to produce.” Jum’ah believes that in-place conventional and non-conventional liquid resources may ultimately total between 13 trillion and 16 trillion barrels and that only a small fraction (1.1 trillion) has been extracted to date.

Even if Jum’ah is correct, the price of oil may not necessarily be low - even if supplies are adequate - because of long-term demand pressures as the world’s population increases.

So, going back to the original question - has the oil bubble burst? Probably, for the time being, but the really big bubble - the dependence on oil - is still growing. When it pops - we may all be wearing suds.

Possibly Related Posts:

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• Treasury Bills “crack the floor” and deflation becomes a greater risk.
• The next “bubble” to burst - US Government debt?
• Franken: I’m stupid enough… I’m vain enough… I’m litigious enough… and doggoneit… I’m still behind.