Gas Prices: Get Comfy with $5, not $3

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(Mike Blake/Reuters)

Gas prices still haven’t reached the ominous $4 a gallon expected in the weekly gas price report out yesterday. In fact, the painful rise in gas prices seems to be slowing (from $3.963 last week to $3.965 today).

But if gas prices do start to drop, don’t get too comfortable. As noted in last week’s blog, at $4 a barrel consumers tend to recoil, which can send gas prices down in the short-term as demand for gas and other stuff subsides and economic activity weakens. But that kind of “demand destruction” won’t last long. Even Goldman Sachs, which predicted last week’s oil price drop back in April, predicts that by next year oil prices will upstage their recent highs.

Why?

First off, the weakening dollar makes the price of all commodities more expensive. The dollar has fallen more than 6% this year amid worries about the U.S.’s precarious fiscal position and the Federal Reserve’s lax monetary policy (near-zero interest rates and quantitative easing). The central bank is scheduled to end its second round of QE in June (a welcome move for the dollar), but it won’t likely be selling the other securities on its books until it sees more signs of widespread inflation across the economic landscape. And a weaker dollar is good for U.S. exports and rebalancing, so don’t expect President Obama or the Fed to launch the kind of currency PR campaign coming out of Europe.

Oil demand is also rising rapidly in emerging markets against a gradual downshift in oil supply. There’s been a steady rise in oil prices in recent years (on top of typical seasonal fluctuations), which is out of step with earlier price booms, according to this IMF World Economic Outlook report.

The real question for gas consumers, then, is how fast oil demand from emerging markets like China will rise against declining oil supply. Non-OPEC and even some OPEC producers like Saudi Arabia will be struggling to offset production declines in maturing oil fields with production from new fields, since those shifts require big investment deals and sluggish infrastructure build outs. Pile on another international disaster ala Japan or the Arab Spring, and things could get pretty hairy.

So should oil and gas prices take a dip tomorrow, keep the next year in mind.

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