What are we to make of the rapid decline in oil prices from over $147 to under $120? I have been a long-time bull on oil and commodity prices, and a bear on the financials. Is this trade, which has been so profitable over the last few years finally over? Is it time to reverse course? I think not.
The key reason for the decline in oil (and other commodity) prices recently is due to spreading economic weakness around the globe. Japan has indicated that it is falling back into recession, Western Europe is weak, and there are even indications that China's growth is slowing (although to a rate that any other country would envy, like to 9.0% or so). There has been relatively little happening on the supply front.
The oil market is one that has very inelastic curves for both supply and demand. This means that small shifts in either can lead to large price changes. All indications are that the changes are mostly on the demand front. In the U.S. drivers have cut back on the number of miles they drive by about 3%, and they are starting to drive in more fuel-efficient ways. They are even starting to check their tire pressure! Contrary to some assertions of the political chattering class, that actually makes a difference, and a difference that is felt today, not seven years from now like increased offshore drilling might.
A major question is, if part of the cure for high prices has been high prices, i.e. $4 a gallon gas has forced people to change their behavior, will lower prices again cause higher prices? Will people start to take their big SUV's out of the garage again? Will they start to accelerate quickly away from the stop light again? Probably not immediately, but in time they will. We will become accustomed to the current slightly lower prices and go back to our old ways.
We have started to see some of the structural changes in the economy that are needed to cut into energy usage in a rational and relatively painless way. Sales of big SUV's are down, while there a long waiting lists for more fuel-efficient vehicles. However, given the size of the overall fleet, these changes will have to be sustained for several years to make a real difference.
While China may be slowing slightly, the growth there is not going to come to a halt, nor will it in India. There have been no major breakthroughs on the supply front and the incremental oil is still going to come from very expensive and difficult places. With growing demand and limited supply over time, some of that demand has to be destroyed.
High prices are the great destroyer of demand. To the extent that demand can be destroyed relatively painlessly (i.e.
