What is happening to oil prices, and will these high prices hurt the economy?

At the beginning of this year, I was lambasted by oil industry analysts when I suggested that oil might average more than $30 per barrel.  They were sure that new pipelines from Russian fields, a rebound in Venezuelan and Nigerian production from the previous year’s disruptions, and improving deliveries from Iraq assured ample supplies. 

I was concerned that reduced yields from natural gas exploration and the continued increase in natural gas fueled electric generators could result in supply shortages that might require higher oil use for other than gasoline use.  I was wondering about the energy intensive growth in China and a rebound in world economic growth.  Of course, I also was looking at weather services that guessed the summer would be hotter than normal. 

As it turns out, production has been stronger from Venezuela and Nigeria than in the previous year.  The Russian pipelines are not yet operational but are approaching completion.  Of course, Iraq has been a major disappointment, but supplies from that country are up from the previous year.

World demand has jumped, as nearly 10 percent economic growth in China has led to almost 19 percent gains in energy material imports by that country.  Oil demand also is up sharply in India while consumption in the U.S. was originally estimated as growing faster than economic activity.  (Revised intelligence from the Department of Energy slashed about a percentage point from gasoline growth in their latest estimates.)

However, the weather has been unusually mild.  Those long term weather forecasts certainly make economic forecasters look good. 

While I did steer investors that I advise into oil production and oil service investments, the best performing investment sector so far this year, I never thought oil would reach $40 per barrel.  In fact, if we do not get relief soon, oil might average that amount for the year. 

Initially, analysts were concerned that the 51 varieties of summer gasoline required by the Environmental Protection Agency would tax our aging refining capacity.  Some analysts remain concerned that refining capacity is insufficient to allow normal maintenance and meet product needs. 

Nevertheless, the latest gasoline inventories are sufficient to meet the needs for the remainder of this driving season.  We need to lower the varieties of gasoline by next summer so that refinery surpluses in one geographical area can more readily meet shortages that might develop elsewhere.  We also need some additions to our refinery capacity.

Frankly, our inventory of crude petroleum remains in the middle of the range that has been adequate in the past few years.  Yet, crude prices continue to push upward for four reasons. 

First, industrial use of oil has been growing 5 percent and this is the product that most clearly can substitute for natural gas if a cold winter threatens supplies.  (Because of the mild summer, natural gas in storage currently is at 2 year highs.)  While problems are unlikely this winter, they certainly remain possible. 

Second, almost everything that could go wrong has done so at some point this year in world oil production.  Norway had a short strike. Nigeria remains unreliable.  Iraq’s delivery system remains under attack.  The engineers needed in Saudi Arabia to expand that country’s capacity have been put at risk.  A tax battle in Russia threatened the loss of 2 percent of world oil production. 

Third, world demand is rising more rapidly than world capacity, especially if all energy materials, including natural gas, are considered.  This could change with increased investments, especially for natural gas delivery systems; but a minimum of two years will be needed to generate ample capacity improvement. 

Fourth, low interest rates have allowed speculators to hold inventory off the market until a disruption provides profit opportunities.  Frankly, as borrowing costs rise, some of this speculative inventory may be reduced. 

While I remain skeptical about significant reductions in oil prices well into next year, I can see some improvement on the horizon.  Two years from now we may again be at $30 oil and $3 natural gas (which currently is more than $6 per thousand cubic feet). 

In the meantime, $300 million per day is being diverted from consumers to pay the higher prices for imported oil and domestic supplies than a year ago.  The average wage earner has experienced a 1.5 percent decline in real earnings during the past year. 

Is this income diversion enough to push the economy back into recession?  I don’t think so.  But it is enough to create a slower growing economy than needed to lower unemployment rates from their current levels.  Until we get some relief in the oil patch, do not look for much additional vigorous economic growth, or much improvement in related equity values.