Please give to The Capital Times Kids Fund.

Confessions of a Money Manager: Can oil prices be headed down?

Ray Unger  —  7/18/2008 1:58 pm

The July issue of Financial Advisor Magazine includes an article by Nick Murray, the marketing guru who entertains investment types with witty stories about how to win new clients. His recent piece, "Ordinary Popular Delusions and the Madness of Oil," however, included a major dose of cynicism about today's energy crisis.

Now, critics may discount Murray's optimistic view about a future drop in oil prices because he's not an expert on energy matters. That's true, but his brief history lesson on past energy cycles struck a chord with me because we experienced many of the same events.

But even more interesting were the headlines about oil discoveries in the last few months -- more on that later.

As I said, he and I were young men when gasoline sold for 25 cents a gallon and oil languished at $3 per barrel. When October 1973 rolled around, however, the world changed. What became known as the Yom Kippur War broke out between a coalition of Arab states led by Egypt and Syria against Israel, disrupting worldwide oil supplies and leading to a three-fold jump in prices to $9 per barrel. I remember being one of those worried motorists waiting in line to "top off" my gas tank.

As Murray pointed out, a new phrase then entered our lexicon: "peak oil." It refers to that moment when worldwide oil production reaches its maximum and begins to decline forevermore. According to the experts, peak oil was just around the corner and stagflation (double-digit inflation and no gross domestic product growth) was our fate. Back then, we also learned how to solve the problem with a windfall profits tax and price controls. That sure helped.

And just as things seemed to settle down, in 1979 Iran experienced a revolution. The Shah of Iran and his monarchy were replaced by an Islamic republic led by the Ayatollah Khomeini. Oil prices tripled again to roughly $40 per barrel, and there were renewed shortages. And, of course, the answer to the problem was a windfall profits tax and price controls.

What Murray points out to the naysayers is that the economic principles of supply and demand actually work. When oil prices spike, demand falls and production jumps. It happened following the Yom Kippur War and the Iranian revolution, and he thinks it will happen again.

So the question is: Is today's energy crisis really different? Isn't the demand side of the equation much different because of China, India and the rest of the world? These economies are growing and their populations are enjoying better lifestyles because of technology. And those lifestyles require more energy. Yes, absolutely true. That alone makes things different.

What's fascinating, however, is the confluence of events that lend credence to Murray's assertions. Note just a sampling of headlines this year on the topic of recent oil discoveries: April 23 on bloomberg.com: "Brazil Oil Finds End Reliance on Middle East, Zeihan Says"; June 3 on bloomberg.com: "Dakota Oil Fields of Saudi-Sized Reserves Make Farmers Drillers"; and June 4 in the Wall Street Journal, "The Coming Oil Investment Boom." In the last article Holman Jenkins Jr. notes that "money is pouring into Canada's massive tar sands" while "a thousand substitutions are taking place on the demand side."

In essence, investors and wildcatters are looking for oil and finding it, and consumers are ingeniously figuring out ways to use less of the stuff. Yes, as economists like to say, these are just anecdotal indications of what's happening in this supply-and-demand tug of war. To get a better handle on this question we need more in-depth research. To that end, Murray suggests we read the feature story of the March 4, 1999, edition of the Economist: "The World Is Drowning in Oil." I'll bet the writers of that article are blushing.

As is always the case in these matters, we'll find out when we find out. The economy is like a horse race. We can read what the odds makers say before the race, but in the end we still run the horses around the track to see who wins. Likewise, the witty marketing guru Murray tells us that when a commodity price spikes higher, suppliers jump in and consumers back off. That's the typical commodity cycle. Given how producers and consumers are reacting to today's high oil prices, it would appear this so-called cycle is alive and well and not broken. If that's the case, oil prices will soon come down to earth.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400.

Ray Unger  —  7/18/2008 1:58 pm