Wednesday, July 30, 2008

On being wrong on gas prices

I wrote a post on June 11 in which I predicted the national average for a gallon of gasoline would be about $4.50 in July. I just passed a station selling it for $3.37. The national average is reportedly $3.95.

Why was I wrong? I used a flawed formula using the futures price of gasoline for July, that's part of it. But, why were all the other pundits and the government wrong in their predictions about $4.50 gas by July?

The simple answer is that global demand has slowed and risks such as hurricanes and other refinery disasters like we saw last year haven't occurred to disrupt supply.This graph was posted on Carpe Diem the other day. Net oil exports used to keep up with the increase in World GDP. About mid-2006, exports began declining while GDP continued to grow. The result is simply an increase in demand combined with a decrease in supply. Why the supply decrease?

One reason may be that the falling dollar began giving people like the Saudis less incentive to pump their oil since they could conceivably wait until the dollar improved (oil is always priced in dollars). That's the situation currently.

The reason oil prices have slackened somewhat lately is because GDP growth is slowing as the U.S. is facing issues and it hampers markets elsewhere. People expect less future demand for oil, particularly from the slumping U.S.

This graph from Net Oil Exports shows that the U.S. and other developing countries actually decreased their demand for oil from 2005-2007. However, China's incredible increase for demand more than offsets this. The emerging economies are thirsty, and China's government subsidizes their purchase of gasoline, driving up world demand and therefore prices.

So, should we prepare for gasoline to eventually fall back below $3? Don't bet on it. I agree with Thomas Friedman that probably the smartest move to make to create a government-enforced price floor. Make it illegal for gas to be sold for, say, under $3.50 so that people will adjust their consumption accordingly and the markets will respond with gas-avoiding innovations.

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