Long Term Oil Prices

Last year, the trend in oil prices were for high short term prices, and then a weakening of prices as we went to future contracts three, four, five years out as there was an expectation that significantly more supply would be coming onto the market and that demand expansion was slowing down as prices increased. However Barry Ritzholtz at the Big Picture catches this great set of charts from the New York Times which shows that long term oil prices are starting to increase significantly, a point I made earlier this month in regard to reconstruction in Iraq.

Standard economic theory predicts that when people are hit with a short term price increase that the most common reaction against that price increase is some substitution but also a lot of borrowing against future revenues in order to tide things over until relative prices fall back into line with long term expectations.

Until recently, people believed that we were facing a relatively short term supply/demand grappling match that would soon resolve itself as demand at a given price would decrease and new supply at this price would substantially expand. Therefore marginal decisions should not be affected that much when consuming fuel as the primary option in a short term scenario would be to borrow a little more money and wait things out. However once people start to believe (as reflected by price) that the price increases are not going to be going back to their previous planning levels, then decisions should start to be made to reflect the new assumption of long term income profiles.

I find this market decision to make a lot of sense as the swing capacity in the global supply market is no longer Saudi Arabia but an array of global guerillas who have the ability to take 5 million or more barrels per day off the market in Iraq, Nigeria, Russia and other nations. Combine this with saber rattling against Iran, and the incability of new supply replacing Iran’s oil if that comes off the market in any significant amounts and time periods, I think that this is a good bet.

So what does this mean for the American economy? Well if marginal decisions are being made in the anticipation that $25/bbl oil won’t be happening anytime soon, any car manufacturer who relies primarily on SUVs for their profit margins is going to be hammered. Land at the outer periphery becomes a lot less valuable, as the cost of a long commute increases, which means the building boom starts to slow down as it gets harder and harder to flip a house and get a favorable appraisal for a new home equity loan. It also means that there is less and less disposable income available, which means either even more debt to maintain current consumption levels and growth path, or a reduction in demand that leads to a recession unless capital expenditures by businesses boom in the next year.

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