The Right Price

So OPEC has kicked the can down the road another two weeks, deferring further production cuts until at least their December 17th meeting in Algeria, when they can better assess the impact of the cuts they've already made--code for observing how badly its members have cheated on their earlier quota reductions. As usual, the cartel's control over prices is much stronger when demand is surging and production capacity strained, than when markets develop considerable slack. This is a much-rehearsed dance, and the market has apparently already discounted it, with the price of light, sweet crude poised to test the $50 mark again this week. The more interesting commentary out of Cairo concerned OPEC's desired price, which is apparently $75 per barrel: well above today's level but far below summer's peak. Wishing won't make it so, but there has been much discussion lately about the "right" price for the most liquid of energy commodities.

I can't help observing the irony that $50 oil, the prospect of which seemed nearly inconceivable to seasoned industry experts only a few years ago, now looks too cheap, not just to OPEC, but also to producers of unconventional oil, developers and supporters of alternative energy, and those concerned about climate change. When you dig a little deeper, however, the insight here seems to be that the absolute price matters less than its volatility, at least from a planning perspective. It's hard for producers of all kinds of energy to plan their business, if the monthly average price of their output--or the key commodity affecting it--can spike up by 150% and then drop by 60%, all within the course of two years. Oil remains a cyclical business, as anyone who's been around it for a while understands, but this is ridiculous.

That $75 per barrel figure from OPEC is interesting for many reasons. It probably represents the minimum level needed to balance the considerable budgetary expansions taken on by its most aggressive spenders, such as Venezuela and Iran, along with pseudo-member Russia. But it also looks like the level that is required to keep additions of new unconventional oil capacity, such as Canadian oil sands, on track. With typical refining margins, instead of the bizarrely-inverted pricing we've seen recently, it would translate into an average gasoline pump price in the US of around $2.50/gal. And because US ethanol distillers are producing well beyond the volumes required to satisfy the federal Renewable Fuel Standard, that would yield an ethanol price after subsidies in the neighborhood of $2/gal., enough to give ethanol producers a 75 cent per gallon "crush spread" over corn at $3.50 per bushel. That's a lot better than the 40 cents or so implied by the current ethanol and corn futures prices.

If the drop to $50 were short-lived, most of those energy producers would experience little lasting impact, other than ethanol firms that have been pushed to the brink by the combination of overly-rapid expansion, tightening credit, and slumping prices. But looking ahead, no one can say with any certainty whether oil will remain here, test $40/bbl, or zoom past $100 again next summer. In this regard the futures market, which last week reflected prices above $70/bbl. beyond 2010, has been a very poor barometer. Nor have the forecasts of government departments or international agencies fared any better at anticipating the volatility that is so disruptive to economies and to the plans of energy companies and oil-exporting countries.

Consumers are in the best position of anyone affected by these developments. If you drive an average car an average amount, your fuel bills ought to be about $90 per month lower than they were in July, which is the equivalent of a $120 per month raise for anyone in the 33% combined federal income and social security tax bracket. Save it or spend it, but don't count on it lasting longer than a year. That means buying your next car with the prudent assumption that at some point in its life, you will be paying $4 or more per gallon, once again.