Despite the predictions of hedge fund managers who are purposely manipulating oil futures by making statements that $5/gallon oil will soon be here to stay, I think that this flies in the face of practical economics. There are very good reasons why oil prices have surged in the past few months. Part of this is due to huge demand in countries like China and India; much is due to the fact that a lot of the worlds huge oil reserves are managed by Venezuela and Russia, who are inept at managing production, thus hampering prices. We also see a deleterious effect here in the US due to the refusal to drill offshore and build new refineries. There are certainly good reasons why oil have hit the record prices that they have.

However, I think basic economics shows that the forces that have created these high prices are also going to cause a classic burst of the oil bubble. The first thing to look at is what is known as the “equilibrium price.” Basically what this does is it figures out, how much are consumers willing to pay, how much are production costs (with a wee bit ‘o profit) and bada boom, you get your equilibrium price. What we have seen in the past few months is that the equilibrium price could not be sustained because of a radical surge in demand and production bottlenecks which could not keep up with that demand. Experts today estimate that the cost to produce a barrel of oil is about $50 per barrel. However, producers can turn around and sell that same barrel for $130 per barrel, there is a huge incentive to pour out as much oil as they possibly can, the temptation is too much to resist because of the profit margin. So, while the forces of supply and demand have created our current oil prices, they will also lower them.

The good news is that we are already seeing a big surge in production of oil. For instance, shale oil costs about $70 per barrel (there are other sources like tar sands and horizontal drilling which also suddenly become profitable at around $70 per barrel). There have also recently been massive oil fields discovered in Argentina, Brazil and the Dakotas. Estimates I’ve read state these new finds are in the multiple billions of barrels. So, from the supply side (Conservatives love supply side) it seems with such profits out there to be had, technology and production is going to lead to greater output of oil. The demand side should also improve as well, although probably more gradually. We can see this in the fact that sales of big cars are down dramatically, people are driving less, Airlines are flying less, etc. Technology will play a large role in this as well. GM recently announced a new hybrid car that uses lithium batteries that will get around 125 per gallon. These cars are due to go into production in 2010. So, as demand falls, so will the cost per barrel.

While it is impossible to say how much oil prices will drop, I feel comfortable in saying that $50 barrels of oil could be here again some day, however $70 is probably more realistic. We saw a similar oil cycle in the 70s and 80s. There was a huge explosion in the oil demand which caused prices to soar, which caused the world to cut back dramatically in consumption of oil and increases in production. However, by the mid-80s prices had fallen from $40 per barrel to $15 per barrel. Time will tell, but never doubt Adam Smith and classic economics, they always prove themselves right.