Talk is Hot Air on Gas Ills

By DAVID MOON, Moon Capital Management
May 7, 2006

Mark Twain observed that everybody talks about the weather but nobody does anything about it. He could have been talking about oil and gasoline prices.

Most of today's talk is about what the government can or should do to solve the problem. News flash: this price surge didn't occur overnight, the government didn't cause it, government intervention is only likely to make it worse, and the core causes aren't going to reverse any time soon, if ever.

The oil price increases weren't caused by Quick Draw Cheney or war in the Middle East. Since the streets of 8th-century Baghdad (then Babylon) were paved with tar derived from the region's oil wells, that region has hosted wars. This is not a new phenomenon.

What is new is the relationship between the changes in demand and supply of refined petroleum products.

In 1990 the world demand for oil was about 66.2 million barrels a day. Refining capacity was 74.5 million barrels a day, giving the world an excess refining capacity of about 13 percent of daily demand. Over the last 15 years, however, the demand for oil has increased much faster than our ability to refine it. By 2005, daily world consumption was 84 million barrels, roughly equal to the world's refining capacity.

This recent price increase is not the result of a supply shock that can be quickly fixed by cranking up oil production.

Refining capacity is the problem ' and that can't be corrected in weeks or months. With no excess refining capacity in the system, the smallest changes in marginal demand trigger a huge change in prices.

And there have been tremendous changes in demand. Look east.

The world's largest oil consumer, the United States, increases its consumption of oil by about 2.8 percent a year. The second largest oil consumer is China. Chinese oil consumption rose 15.8 percent in 2004 and shows no sign of slowing. This doesn't even take into account the accelerating demand in India.

There's your culprit. The economies of the world are strengthening much faster than our ability ' or more likely our willingness ' to meet their demand for petroleum.

Consumer reaction ' not talk ' has, in total, been a collective yawn, because over time gasoline expenditures have declined as a percentage of consumer expenditures.

In 1981 U.S. consumers spent 6.2 percent of their pre-tax income on gasoline and motor oil. Goldman Sachs estimates that oil prices would have to reach $105 a barrel for the consumer 'gasoline burden' to reach that percentage of 25 years ago. The investment bank also estimates that prices would have to reach $135 a barrel before having any significant influence on consumer capital decisions, like what kind of cars to buy.

In other words, at $70 a barrel expect consumers and commentators to talk more than actually do anything about these increasing oil prices. It's either oil or the weather. Or perhaps football, but that's still three months away.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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