No one likes to pay $50 to gas up a car, but consumers should keep last week’s news of high oil prices in perspective. Oil at $67 per barrel in August 2005 does not mean gas at $2.50 a gallon for the next five or 10 years.
When commodity prices make large swings, particularly in reaction to fears and rumors, they tend to overshoot. Crude oil prices may continue rising for some time, but history and economic theory demonstrate that they probably are already above what the market will support in the medium term. Prices will eventually drop below current levels.
Take historical examples. Crude oil prices spiked in 1973, 1979 and 1991. Adjusted for inflation, the 1973 and 1979 surges reached higher levels than current ones. In all three cases, prices eventually retreated. Then there were years-long periods during which crude oil and gasoline prices stayed well below these peaks.
In all three cases, some observers argued that all experience was irrelevant and that all the old rules were off. We hear the same warnings today. They are wrong.
This is not to discount changes in fundamentals in recent years. Dramatic economic growth in China and India is boosting oil consumption. U.S. oil consumption continues to grow, though not as fast as the overall economy. Conflict in the Middle East has escalated and may remain high for years.
This may mean that oil prices will not return to the $28-$32 range OPEC stated as its long-run target only a few years ago. It does not mean, however, that prices will never again drop below $60, $50 or even $40. Fundamentals simply do not support $60-plus oil in the medium term.
Oil prices overshoot in both directions. The near-$10 price we saw a decade ago did not represent a sustainable equilibrium any more than $67 does today. Nor is overshooting limited to oil.
Grain prices overshoot long-run trends in both directions with remarkable regularity. It happened with the Russian grain deal in 1972-73, the drought of 1988, and with flooding in 1993. Minnesota corn prices over $5.00 per bushel in 1996 were followed by sub-$2 prices less than two years later.
The same patterns exist in stock prices, foreign currencies and at times in housing. Overshooting is greatest when uncertainty about the future is high. Rumors and events with undefined impacts such as the death of a Saudi leader or drought in the western Corn Belt drive people to expect the worst.
Like Shakespeare’s coward who “dies a thousand times before his death,” fears in commodity markets are worse than reality. This is reflected in old traders’ advice to “buy on the rumor and sell on the news” and in the Rothschild bank’s maxim that “the time to sell is when the blood is still wet on the streets.” Both weather and political news cause much greater price fluctuations in the short run than in the longer term.
Don’t look for $1.29 gas very soon. But don’t expect to keep paying current prices forever, either.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.