What Will Bring Down Fuel Prices?
Last night's News Hour on PBS featured a segment on high gasoline prices and the public's reaction to them, ranging from outrage to bland acceptance, and including the standard level of denial that trading in a sedan or minivan getting 20 miles per gallon for a Suburban that gets 12 might be part of the problem. There was an intelligent discussion of the contributing factors, with crude oil prices leading the pack.

Other than a fall in crude prices, what could bring gasoline prices back to more normal levels in the near future? Lower demand? Not if SUV sales continue at their current, record rate, and not if the economy stays on a recovery path. A relaxation of the confusing welter of conflicting regional gasoline specifications? While the EPA is considering temporary waivers that would ease localized market distortions, this would will do little to reduce the current record average price. What about an easing of refinery bottlenecks? That would take a couple of years, and with the refining segment finally earning healthy profits, for once the industry seems disinclined to destroy them by investing in a wave of expansions. This takes us back to crude prices.

The list of culprits responsible for current high oil prices is long and varied: OPEC production policy, growing demand in China, the popularity of SUVs, instability in the Middle East, and a global economic recovery, particularly in the US. Other factors include fuel-switching due to tight natural gas supplies here, and continuing production problems in Venezuela in the wake of last year's disastrous petroleum industry strike. It is not that hard to account for the oil prices you have, but predicting future prices is a much tougher proposition.

What could cause the crude price to fall, and thus provide some relief on gasoline? Within three to five years, many things could and probably will drive prices back down to a more normal range, say between $20 and $25/barrel. But in the short run, assuming the demand factors I mentioned in the opening paragraph don't change, there is only one thing that will bring prices down: a visible growth trend in oil inventories.

If you were only going to look at one factor to try to assess whether the price of oil will rise or fall over a very short period, the level of crude oil inventories--excluding the government's Strategic petroleum Reserve--is your best bet. These inventories consist of oil that has already been produced or imported and is being held in tanks at refineries or somewhere in the distribution network. If crude inventories go up for a month and are above the level for the same time last year, the chances are good that the price of West Texas Intermediate, the marker crude traded on the NYMEX futures market, will fall.

According to the reports published by the Energy Information Agency of the Department of Energy, US crude oil stocks are currently just under 300 million barrels, up about 10% since the beginning of the year. This still puts them well below the average of the last five years. Inventories would have to increase a lot faster, say by an additional 10-15 million barrels over the next month, in order to signal a drop in prices. That looks unlikely, barring a change in OPEC policy that would make available the oil necessary to raise inventories.

At the moment, OPEC enjoys a remarkable degree of market control. Global conditions are ideal for them to be able to control prices through tight control of production by their member countries. OPEC's stated rationale is that failing to cut production now would lead to a rapid buildup of stocks and a price collapse that would be harmful to both producers and consumers in the longer run. On the surface, this is not as silly as it sounds. The price collapse in 1998 connected with the Asian Economic Crisis was a major factor in the wave of industry consolidation that followed, and has kept non-OPEC oil production on a slower growth path.

But in this case, OPEC's concern is fatuous and self-serving. All other indicators point upward, which was hardly the case in 1998. Demand is growing all over the world; non-OPEC oil production is stalled for the moment, as the North Sea reaches its peak of production, and as Russian production hits the limits of existing infrastructure. Nor is Iraq in a position to flood the market. And natural gas, which has lured demand away from oil for the last decade, has plateaued for now. From a structural standpoint, the risk of a price collapse right now is very low.

OPEC ministers point to the high level of speculation in the market, principally by hedge funds, as further rationale for their need to manage prices. But prices for delivery of physical crude have not weakened much relative to the futures prices, as one would expect in a speculation-driven market. This says that it is not just "paper barrels" that are in short supply, but real ones.

After going through all these factors, I can only see one logical answer to the question I posed above. The only thing likely to cause crude prices to fall any time soon is a change in OPEC policy. If you want to know what the price of oil will be over the course of the summer and into the fall, you need to ask the question in Riyadh and the other OPEC capitals. For now, at least, the price of oil will be largely what the Saudis decide it should be.