As the saying goes, “Oh how the mighty have fallen.” The price of oil has been in a virtual freefall since it’s peak over the summer. Falling from roughly 147 dollars a barrel, to its current lows of 46 dollars a barrel, some observers are wondering just how low it will go? For me - my prediction is oil will finally slide back to about 25-30 dollars a barrel. Yes that’s right - you could be paying a buck-20 a gallon again for gasoline at the pumps. Why?

Three things have happened over the summer and are continuing to happen that revealed why the price of oil was so high. Those things are 1) actual demand fell considerably in the United States and did not pick up elswhere, 2) oil no longer proved itself to be a particularly good hedge against a weak American dollar, and 3) OPEC’s ability to control the price of oil was greatly reduced on the slide because of the dependency of oil producing states on oil’s revenues. Factors 1 and 3 are the most important here in understanding why oil is likely to be depressed now for some time (but not for the long-term).

Actual demand for oil has fallen considerably. The average amount of fuel products such as gasoline and diesel supplied by refiners for the past four weeks was 7.9 percent less than a year earlier, according to a U.S. Energy Department report yesterday.

Moreover, as the recession is now looking increasingly global, it will begin to affect more deeply the economies of China, India, and Latin America, the three largest petroleum consumers outside of the United States. On that basis alone, oil prices could fall to as low as 20 dollars a barrel if recessionary pressures cause equivalent declines in those markets as they did in the US.

Gas prices declined for the 78th day in a row Thursday to a national average of $1.789 a gallon, according to motorist group AAA.

Some economists and observers are suggesting that eventually low gas prices will stimulate demand. I don’t believe that this analysis is correct. There are a couple of reasons that I believe prices will continue to be in free fall for quite some time.

• During the peak of oil prices, and the run up to the peak, businesses and consumers suffered significantly under high prices. That money is not reclaimed now by lower gas prices. The wealth transfer is permanent. The fact that consumers are not paying high prices now helps somewhat, but they still have to recover in real wages and income from the period of high prices.
   
• Many consumers and businesses made long-term structural changes as a result of high prices. For example, the airline industry eliminated as much as 60% of its capacity as a result of unprecedented prices for JET-A fuels. Similarly, busineses that relied heavily on petroleum (transportation, shipping, etc.) also made long-term business decisions because of a sustained run up to the peak. Oil prices rose over a two year period from 30 dollars to 147 dollars. Neither businses or consumers can react to the price drop more quickly than they did to the price increases.
   
• Recessionary pressures make long-term calculations about the price of oil difficult. In a risk adverse environment, businesses will be unwilling to add capacity or incur greater costs merely because the price of oil has fallen. This is being most obviously shown in the oil industry itself. All planned new investments have basically been shelved. Oil developers have little incentives at the moment to increase any exploration or refining projects beyond what’s already committed.
   
• Recessionary pressures are also creating a situation where consumers are looking to spend less. This means often getting rid of cars and relying more on public transportation. Moreover, with the credit crunch, the purchase of new automobiles, the largest use of petroleum at the “consumer” level, is stymied. With fewer cars being driven and sold, the overall demand for gasoline will fall. While oil is used to make other products than gasoline, fuels are by far the most visibile and dominant factor in overall petroleum demand of the United States (and elsewhere).

Compliance with existing supply quotas is “not good enough,” based on current forecasts, said OPEC Secretary General Abdalla El-Badri. He also urged non-OPEC members Russia, Mexico and Norway to restrain supply, as they did a decade ago when prices slumped toward $10 a barrel.

Bottom line is - everyone I think is racing to the bottom. Just as OPEC was unable to stop the slide in the 1980’s after the recession of the 1970’s - it will be unable to stop the slide this time as well.

Thus, if there is a silver lining in the economic criss - it’s gasoline is considerably cheaper. At least for now.

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I have been getting emails from readers essentially asking me to do a post on oil - why is it so expensive, and what, if anything should be the GOP’s party platform on energy. While energy economics is not my specialty - I do understand commodities markets, and I believe I probably understand better than most what’s causing the run in the price of oil. Since I’m all about serving my readers at Right Commentary - this post is for you.

First, the current “oil crisis” is a crisis of our own doing. In 2004, several economists and energy experts noted that at the current rate of industrialization, supplies of energy would necessarily tighten over the next decade. At the time, few seemed to understand this fact, since oil was about $38/barrel on average, and gasoline costs were approximately $2/gallon. From 2004 to now, the price of both crude oil and gasoline have skyrocketed. Oil is now three and a half times what it was three years ago, and the price of gas has more than doubled. Thus, the “crisis” in oil didn’t just “sneak up on us” in the last year. Prices have been steadily rising steadily since 2000, after about a decade of relative price stability - with oil prices ranging from 16-23 dollars per barrel.

Also, demand for oil hasn’t exactly snuck up on us either. In 2004, predictions were made that the world wide energy intensity would increase. While energy intensity in the US is falling, in large part because of economies of scale and efficiencies made in the use of energy, overall energy demand is skyrocketing. Oil demand alone has increased by more than three million barrels a day. As countries like China and India become more industrializes, and the demand for products that contain oil worldwide grows with the world’s population, demand for oil will continue to increase. China and India are especially critical to this discussion because their rapid growth rates mean they will account for the single largest chunk of the “increase” in the use of oil over the next 20 years.

Second, some things have happened since 2004 to the US economy that have made oil expensive. The first element to the “economic piece” of the puzzle is the value of the US dollar. From 2005 to now, the dollar has steadily dropped against major currencies. This is in part because of an investor-led devaluation due to the massive borrowing of the United States since 2003 to finance the wars in Afghanistan and Iraq (along with an increasing debt burden brought about by entitlement programs). The second piece is that as the US dollar falls, investors will look to other types of investments to maintain the rates of return needed from their investment portfolio. One good way to do that is to invest in OIL. These people are not speculators per se (I’ll get to the speculation in amoment), but they are buyng and selling oil in both the spot and futures markets as hedges against inflation and a weakening greenback. That fact makes the competition for oil in the market more intense - and as the price goes up - so do the returns - and it draws in more dollar denominated assets. Further, this cycle doesn’t seem to be done - last week, a drop in US employment figures lead to a $11 increase in the price of oil in one day. (BTW - for those of you who hate hedge funds and speculators in oil, most of them got their asses kicked that day, as most of them were speculating AGAINST a rise, and got whammied when the market reversed on them by the dollar traders.) As the US economy weakens, it necessarily drives a price increase in oil.

Third, despite what idiots in the Democratic party may say - the reality is, the market is significantly under supplied a this moment. Demand is probably outstripping supply by about two MILLION barrels of oil a day. That is why the Saudi’s announcement  to increase oil supplies had no appreciable affect on the price of crude oil. It was instantly absorbed. In order for supply to matter - the amount of supply must be more than demand, and allow for the development of oil inventories in major importing nations. Once inventories rise high enough, worldwide demand slows down, and prices begin to drop. As it is right now, the supply is incredibly tight worldwide - and events like shutting down refineries in Nigera make a tight market even worse.

This brings me to the fourth concern, namely, political instability. Most of the world’s “deliverable” oil (I say that because it highlights the fact that there are billions of barrels under the US we refuse to bring to market) is in the hands of totalitarian regimes that suffer significant political instability. Saudi Arabia is perhaps the key worldwide to oil - and that regime is always under threat from challengers, al Qiada, and other forms of political instability. Hugo Chavez (Veneuzela)- where the United States gets most of it’s oil from - has repeatedly suffered attempts on his life and coup d’etats. Investors worldwide, and purchasers of oil, watch the instability patterns very closely, and attempt to guage the impact it will have on supply. As political instability increases - such as threats to attack Iran (an OPEC state) - so will the price of oil.

This brings me to the last concern - price speculators. Speculation has been demonized and scapegoated recently because it’s a simple political ploy to blame “evil market speculators,” since in large part no one has a clue who the heck they’re talking about when they say that.

First of all - market speculation is not evil. Almost all commodities markets have what are called “futures” markets. The futures markets help businesses that use commodities smooth out their costs over time. In situations where a  time lag exists where commodity is produced and then consumed, businesses will try to ensure their “cost structure” ahead of time by trying to secure the rights to purchase the product at a specified date and price. This is essentially what futures markets do - they allow consumers of a product to fix in a date and time certain, for a certain price, the commodity they will buy. For example, airline companies smooth out the “ups and downs” in jet fuel prices by buying futures for the delivery of jet fuel. Coca-Cola buys futures to ensure they have enough sugar and corn to make soda throughout the year - and it makes it easier for them to know what the price will be - since it’s fixed in advance.

Secondly - oil speculation is largely being driven by the weakened dollar and US economy. As hedge funds look for ways to improve their returns - OIL is a really great investment. Oil prices continue to provide good returns, and because they are dollar denominated assets with high degree of liquidity - they make for an easy target for investors of large sums. While it is true that some speculation is truly that - guys going “Gee Bob, what are you willing to pay for oil in February of 2009?” Most of the speculation is really a hard-nosed calculus of supply and demand, evaluations of political instability in oil producing nations, the strengths and weaknesses of refining capability and relative energy transformation coefficients, and other factors that make investors wonder which way the price of oil is going to go. While energy traders in the market have grown as the price of oil has increased - I don’t think it’s really true that speculation is driving the market. The other four factors I’ve mentioned are much more prominent than speculation, thus, I’m dubious of efforts by people such as Barrack Obama to regulate “speculators.” Speculation is a political scapegoat.

Okay - whew! So as you can see, a great deal goes into what makes oil prices rise and fall. All of that said - what makes for the right politics for the GOP? The answer is quite simple - we have to increase our supply of crude oil by making exploration, energy diversification, and self-sufficiency a prime goal of a national energy policy. Turning off lights, and driving less will not materially help us. Deciding the spotted owl is more important than avoiding $30/gallon gasoline is ridiculous. We need a serious energy policy.

Any energy policy needs to include, in my view, the following key items:

• We need to exploit and explore all of the oil within the waters of the United States and on US territory or soil. Now, I want exploration done in a ecologically sound way - but saying we can’t drill no matter what is suicide. There needs to be a balance between our energy needs and the ecology - one cannot take absolute preference over the other.
• We do need to improve energy efficiency - increasing automobile efficiency among other variables. We should be providing incentives to automotive manufacturers to make more efficient cars. We should also be providing incentives to develop alternative fuels.
• We need to STOP all incentives for gasohol. Ethanol is a disaster. Let the people of Iowa find some other subsidy. By tying energy stocks to food stocks - we’ve screwed up two markets. If ethanol is truly going to be viable in the market - the alcohol needs to be derived from something other than corn, and those technologies are available.
• We need to stop all this stupidity about nuclear power and build power plants. We are an energy intensive society that will need more energy. While nuclear power is not danger-free, compared to other types of power generation activity - it is safer, produces less waste (in terms of volume), and is ecologically manageable. For all you lefities out there who love the Europeans - they’re building nuclear power plants like mushrooms sprouting all over a field.
• We also need to improve our ability to use coal cleanly. We have vast amounts of coal, which cost less per kilowatt than other types energy generation - especially oil.
• We need to develop a comprehensive incentive strategy for firms and scientists to develop alternative energy. We put men on the moon. We can find ways to improve our energy supply - it’s just a matter of time and money.

Those elements would make for a logical energy policy consistent with the Republican platform of free-market enterprise. The Government’s inaction is largely responsible for the mess we are in - it’s time to get our act together and start making America less dependent on the likes of Chavez and King Abdullah.

One final word - when Liberals talk about global warming, when the talk about not drilling in ANWR, when they talk about placing “global change” against global development - that accounts for at least 20-30 cents per gallon at the pump… and rising.

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Sen. Barrack Obama, in addition to wanting to tax the living daylights out of you, has also decided, it is good you pay more for gasoline. Responding to the recent 180 by the President and Sen. McCain on oil exploration, Senator Obama said this:

Offshore drilling would not lower gas prices today. It would not lower gas prices this summer. It would not lower gas prices this year. In fact, President Bush’s own Energy Department says that we won’t see a drop of oil from this proposal until 2017. It will take a generation to reach full production. And even then, the effect on gas prices will be minimal at best.

Believe me — if I thought that there was any evidence at all that drilling could save people money who are struggling to fill up their tanks by this summer or this year or even the next few years, I would consider it. But it won’t. And John McCain knows that.

Now I realize Sen. McCain has said he doesn’t know much about Economics. Apparently, neither does Mr. Obama.

Well I AM an economist - so let me begin with some very simple observations. If you like, you can play along at home while reading…

How many people, in the year 2017, believe they will be buying gasoline? (Raise your hand - my hand is up.)

Okay, so we’ll ALL be buying gasoline. Oh and by the way, you and everyone else, is going to buy more gasoline - more in China, more in India, more in Pakistan, more in Africa, more in Latin America, as these areas continue to industrialize and consume more fuel.

World wide energy demand, according to economic experts, will increase 40% between now and 2020. Crude oil is just one component of that (about 60% of the total energy consumption) and the amount of crude oil consumed will continue to rise world wide.

Now, let’s say between 2008 and 2017, no new supply is found. In reality, that’s not going to actually happen, but just for illustrative purposes for the moment, let’s assume that.

If supply is fixed, and demand is rising - what happens to price? I know at least a few of you are raising your hands going “OH! OH! I know! I know call on me!”

Presume I called on you - yes, you’re right, price goes up. As the graphic demonstrates, when supply is fixed and demand rises, price must increase. More is always supplied at a higher price. Suppliers want to supply their goods for the maximum price possible. Consumers want to consume for the lowest price possible. When demand is increasing, and supply is constant, the price must necessarily increase to the level where everyone who truly want to “buy oil” has paid “the lowest price possible.” It’s like KISS concert tickets - supply is limited, so only the most die hard KISS fans are going to get in, and they’ll pay 200 dollars a ticket if necessary (or more.)

Now, as I hinted at - supply is actually not going to be constant - in fact, it may decline during this period. The bottom line is that the Saudis and other oil producers are having more and more difficulty getting maximum pump yields from their fields. This is somewhat of a normal consequence of pumping oil. Oil wells go through stages of production, you explore, you tap, you pump, exploit the oil until the yields drop, then abandon the well (even though oil may still be “pumpable” - it’s often not cost effective to do so).

If production world wide slips a bit - and demand rises - then it’s a double whammy…  a fire happens at the warehouse with the KISS tickets and burns at a rate of 1000 tickets a day. Demand skyrockets for the remaining tickets, and they try to sell as many as possible while the warehouse burns, but the supply always gets smaller.

So Mr. Obama - deciding not to explore for oil is not only dooming America to higher gas prices, you ensure that America will continue to be in a tenuous race for energy with China, Japan, Russia, our European Allies, and OPEC. We’ll have to continue to rely even more heavily on unstable oil-producing nations.

And to add insult to injury, Mr. Obama, our friends the Chinese are busy drilling OUR oil 60 miles off the coast of Florida, in a joint venture with Cuba. Where is your moral indignant outrage for that?

Here are the facts:

• U.S. law prohibits the development of approximately 38 billion barrels of undeveloped oil resources (19 billion barrels onshore and 18.92 billion offshore).

• U.S. law prohibits the development of approximately 180 trillion cubic feet of undeveloped natural gas resources (94.5 trillion cubic feet onshore and 85.7 trillion cubic feet offshore).

• According to a recent USGS survey, the largest known oil shale deposits in the world are in the Green River Formation, which covers portions of Colorado, Utah, and Wyoming. Estimates of the oil resource in place within the Green River Formation range from 1.5 to 1.8 trillion barrels. Not all resources in place are recoverable. For potentially recoverable oil shale resources, we roughly derive an upper bound of 1.1 trillion barrels of oil and a lower bound of about 500 billion barrels. For policy planning purposes, it is enough to know that any amount in this range is very high. For example, the midpoint in our estimate range, 800 billion barrels, is more than triple the proven oil reserves of Saudi Arabia. Present U.S. demand for petroleum products is about 20 million barrels per day. If oil shale could be used to meet a quarter of that demand, 800 billion barrels of recoverable resources would last for more than 400 years.

Still think we can’t change the price of crude oil Mr. Obama?

Drill here…

Drill now…

Invest in America. We need plentful energy if our society is going to thrive, survive, and be prosperous.

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Washington, D.C. (politico.com): The House moved quickly to override President Bush’s veto of the Farm Bill Wednesday - so quickly that lawmakers may have to do it again.

One hundred Republicans joined 216 Democrats on the 316-108 vote, which came just hours after the White House had returned the $307 billion, five-year measure.

The action reflected growing tensions between Congress and the White House over budget priorities. And a second showdown could come Thursday in the Senate when Democrats will press for a major expansion of GI education benefits to help veterans of the Iraq and Afghanistan wars.

But the new majority hurt its cause in the case of the Farm Bill. In the rush to act before the Memorial Day recess, the leadership ignored the full consequences of a clerical error in which the third of the bill’s 15 titles had been dropped from the text presented on parchment to the president for his signature or veto.

After consulting with parliamentarians, Majority Leader Steny Hoyer said that the House had properly overridden Bush on those portions on the parchment - but that left Title III, which covers trade and important international nutrition programs, out in the cold.

To remedy the situation, the Maryland Democrat said Wednesday night that the “likely” solution to the parliamentary snafu will be for the Congress to send Bush a newly numbered bill with the full text of the one voted upon last week.

“We can pass a full bill again. I think that’s likely, or we can just do Title III,” Hoyer said. He had not yet consulted with Minority Leader John Boehner (R-Ohio) but signaled that passing the bill again was the cleanest route and one he hoped could be done quickly.

Toward this end, the House Rules Committee cleared the way Wednesday night for an agriculture related bill to be brought up for a quick vote, and Hoyer’s hope is that Congress waves the newly numbered but familiar bill through, Bush vetoes again, and the override votes resume.

Then again, little about the Farm Bill has gone smoothly. And one casualty already in the whole affair could be plans for passing the 2009 budget before the recess. Hoyer indicated that will now wait until lawmakers return in June; the rest of this week will be devoted to clearing up the Farm Bill confusion and debate on a defense authorization bill.

The day had begun with more confidence. Stepping out of character, the Senate’s mild-mannered Finance Committee chairman, Sen. Max Baucus, had even taunted Bush for having brought “a knife to a gunfight” in the Farm Bill veto battle, which the Montana Democrat dismissed as “a speed bump on the road” toward enacting the legislation.

The macho talk reflected growing disagreements between Congress and the White House five months before the November elections. The Democrats’ proposed budget resolution would add $21 billion to White House appropriations requests for the coming year. And education is a signature issue for the party, from public school reading programs to GI benefits.

More than one-third of the increased appropriations identified in the new budget resolution would go to education accounts. And GI college benefits are pivotal to Senate votes Thursday related to a larger spending package for military operations in Iraq and Afghanistan.

Jobless benefits and Gulf Coast aid are part of the same debate. But the expanded GI benefits-costing $52 billion over 10 years-have become a rallying cry for Democrats, who are pressing Arizona Sen. John McCain, the presumptive Republican presidential nominee, to join in the effort because of his support of the war in Iraq.
Thus far, McCain has refused, preferring an alternative bill that puts more focus on benefits for the families of career officers and noncommissioned officers. But even this bill is now projected to cost $38 billion over the next 10 years. Despite the continued sniping, New Hampshire Sen. Judd Gregg, the ranking Republican on the Senate Budget Committee, predicted some blend of the two plans is now likely to clear Congress before the elections. Majority Leader Harry Reid (D-Nev.) is poised to press hard on Thursday for his preferred version of the GI education bill, sponsored by Sen. Jim Webb (D-Va.).

Reid is expected to first seek 60 votes on a larger domestic spending package that includes aid to Gulf Coast states still recovering from Katrina. But if that fails, he can then come back with a cleaner version focused on the Webb bill, where he has said he has the votes to prevail.

In all the maneuvering, both political parties lose sight of deficit reduction as a major goal. And as much as the White House has tried to draw a firm line on spending, it is undercut by its own demands for ever more emergency funding for U.S. military operations and foreign aid initiatives.

Many Democrats argue that the GI education benefits should be viewed as part of the enormous cost of the wars in Iraq and Afghanistan. At the same time, farm-state Republicans complain that the commodity title of the Farm Bill–costing $7 billion a year–is not a fair target for Bush to choose at this juncture “I’m a little bit amazed that a quarter of 1 percent of federal spending got the president’s attention. Why this; why now?” said Rep. Marilyn Musgrave, a social conservative from rural Colorado who helped whip Republicans in support of the override. “The Farm Bill’s right up there with motherhood and apple pie, and back home, they don’t understand why the president is vetoing it.”

For its part, the White House gave no hint that it had know the Title II was missing, since the administration works more from the legislative conference report than the parchment text. But in his veto message, Bush argued that at a time of high food prices and record farm income, this bill lacks the program reform he wanted, especially tighter payment caps that would bar wealthy individuals from receiving continued subsidies.”

Singling out “earmarks and other ill-considered provisions,” the president said that “rural and urban Americans alike are frustrated with excessive government spending and the funneling of taxpayer funds for pet projects.”

Farm Bill advocates argue that the measure incorporates more reform than its critics acknowledge, by improving the reporting of subsidy payments and imposing new income caps that can be tightened in the future. And when compared to the 2002 Farm Bill, which Bush signed, the cost of the commodity title is dramatically less.

Much of this is the natural result of higher crop prices, which have made the old safety net price support and loan programs irrelevant in many markets. But a comparison of 2002-2006 spending and that projected for the next five years is striking.

Nutrition programs will account for more than two-thirds of the $307 billion cost of the bill, a dramatic increase. At the same time, the different pieces most important to individual farmers have changed significantly.

For example, from 2002 to 2006, commodity programs cost the government about $74.9 billion compared with $35 billion projected for 2008-2012. At the same time, conservation spending would increase significantly to about $25 billion. And even after the savings promised in the new bill, crop insurance premium subsidies would grow to $27.4 billion, almost twice the $14.6 billion cost from 2002-2006.

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Washington, D.C. (rightcommentary.com): Gold continues its climb above $900 per ounce, fueled by record oil prices and a weak U.S. dollar. Gold is currently trading around $927 per ounce, up approximately $5.

According to an article in today’s MarketWatch, analyst Peter Grandich told his subscribers, “Oil is obviously leading gold and if the historical gold vs. oil ratio ever returns, we could see gold as high as $1,500…”

Citigroup analyst, John Hill, sees gold possibly doubling in coming years according to an article in the Financial Post entitled Gold price may double in long-term: Citigroup. Mr. Hill told clients: “Longer term, we would not be surprised to see gold double from current levels as the global policy prescriptions for the credit crunch remain powerfully and uniformly re-flationary..”

Silver is currently trading at $17.87, up $0.16. Platinum has gained $40, trading at $2,182.

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