Oil prices recently flirted with $100 per bl and the consensus of most analysts is that it is only a matter of time before that level is taken out, and we move ahead to ever higher prices. The argument is that with the developing economies of China, India, and Russia growing rapidly and representing nearly half of the world's population, it is inevitable that the price of oil can only rise as far as the eye can see.When I hear the term "as far as the eye can see," I recall how often it turns out that the eye can't see very far. Indeed, it is almost a certainty that the equilibrium price for oil is far less that the current selling price. Anytime the as-far-as-the-eye-can-see crowd is at work, you can bet that they have laid up lots of bets on oil and, thus, there is a speculative premium in the current price.
I said in a September 2006 blog that what always kills real estate is the gap between market prices and rents. When rents begin to lag way behind prices, it means that the supply of housing is greater than the demand, and the cost of carry will soon become a factor for speculators in the decision to hold or sell the property, even if prices appear to be moving higher.
As it relates to oil, I believe that the best measure of "true demand" is the price of gasoline at the pump. Gasoline prices are thought by many to be inelastic. After all, we have our lives to live and; well, we have to drive to live, etc., regardless of price.
I have been thinking for the last couple of years that to assume that gasoline prices are inelastic is probably not justified. The fact that demand for gasoline has not fluctuated much with higher prices in the past may be because total fuel costs for the average household budget has been a relatively small percent, in the range of 4%-5%.
The chart above is a scattergram (you may want to click to enlarge) that shows, as you would suppose, there is a very high correlation between crude oil and gasoline prices -- R2 of .94. Note the three arrows I have drawn on the chart at the far right. These points, which are the last three months, suggest that prices at the pump are much lower than we would expect them to be based on their historical relationship to crude oil. For instance, last week when oil surged to near $100 per bl, gasoline prices at the pump (Midwest) should have been near $3.50 a gallon. Oil prices in my region never got above $3.15. Currently with crude prices near $90 per bl, the chart indicates that prices at the pump should be near $3.20. Bloomberg shows that the prevailing price in the Midwest in currently $2.95 a gallon.
The lag in prices can be the result of only three reasons. 1. Oil refiners and marketers are holding down the price of gasoline, 2. Consumers are balking at paying much above $3.00 a gallon, or 3. A combination of both.
If consumers are balking at higher gasoline prices, crude oil prices would at the least flatten out, if not fall. The reason oil prices may fall more than you might expect is because of the rampant speculation in crude oil futures.
I'll keep you posted on this trend in future blogs. Could it be that some elasticity of demand is appearing? We'll soon see.
