Politics & Policy

The Oil Bubble Is Next to Burst

The free market is the ticket for this commodity round trip.

Tune in to any of those financial news networks and you’ll be sure to find a commodity guru still predicting $1,000 an ounce for gold and $100 a barrel for oil. Should the little guy jump on this bandwagon? Or is it too late? Well, the recent plunge in some commodity prices is giving speculators second thoughts about the durability of the commodity bull market.

 

The price volatility of another well-known commodity, natural gas, can be instructive here. As the world frets about energy shortages, natural gas is suffering from rising inventories and sluggish demand. Last year, the gurus were looking for $20 per million BTUs of natural gas. Recently, that price dropped below $6 per million BTUs. Natural-gas price fluctuations, as represented in the following chart (prepared by the Federal Reserve Bank of St. Louis), indicate the forming of a price bubble, with natural gas prices rising from a low of approximately $6.50 in March 2005 to a peak of $14.50 in December 2005. But once the peak heating season reflected a warmer-than-normal winter, the price of natural gas plummeted back below the low levels of 2005. (Incidentally, many tech stocks charted much the same course between 1998 and 2002.)

 

 

One irony here is that little news about the recent natural-gas round trip makes it into the media. Why aren’t raucous politicians singling out gas-company executives — labeling them patriots for sacrificing profitability in the name of helping the country through an energy crisis? The reason for the silence is that energy-company executives do not determine energy prices and the politicians know it. In Washington, good news is no news — so you won’t hear any good news about the fall in natural gas prices.

 

On the other hand, when it comes to the bad-news rise in oil prices, Washington politicians are not only vocal, they are predictably nearsighted in their proposed solutions: Punish the auto companies by imposing higher CAFÉ requirements! Impose windfall profits taxes on oil-company profits! Prohibit drilling for oil off our coasts and Alaska! Pillory the oil-company execs!

 

But our experience from the energy-price run-up of the 1970s reminds us that free markets will resolve high energy prices, while politicians will only exacerbate them.

 

In particular, here are a few reasons why free-market factors will erode the current high price of oil: More windmills and solar power will pop up, the billions of dollars invested to get oil from tar sands will begin paying dividends, nuclear power will reincarnate, a rising number of drilling rigs will begin operating within the U.S., smaller cars with higher fuel mileage will proliferate, substitute fuels such as ethanol and hydrogen will take hold, and on and on.

 

Efforts to innovate, substitute, or even conserve at the same time the oil supply is expanding will create the perfect environment for an oil-price decline. Back in the early 1970s, and then again in the early 1980s, high oil prices led to lower oil prices. Oil bulls rely on rising global demand, but few of them fear a rise in supply through incremental oil as well as new energy sources that will displace oil as the primary fuel.

 

When Hertz begins to charge less for big car rentals than small car rentals, as pointed out in a recent Wall Street Journal article, the handwriting, as they say, is on the wall.

 

From a high price eclipsing $75 per barrel, oil has recently fallen below $68. If the fall in natural-gas prices is a good indicator, oil prices still have a long way to drop.

 

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.

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