Editor's Note

07/19/2007 12:00 am EST

Focus: COMMODITIES

Howard Gold

Founder & President, GoldenEgg Investing

July 19, 2007

This week crude oil prices came within a drop of last summer's all-time record of $78.40 a barrel, while US retail gasoline prices hovered above $3.00 a gallon.

How high can they go? How about $100 oil and $4.00 gas? 

Those numbers were unthinkable a few years ago. But some recent reports suggest they may get there over the next few years. And it could happen sooner if certain unexpected events occur.

It's right out of economics 101-limited supply combined with surging demand. While supply is as tight as an oil drum (there are some estimates that oil producers are operating at an astonishing 99% of capacity), demand is strong, particularly from China and emerging markets.

The International Energy Association last week projected global oil demand will grow by 2.2% a year through 2012, assuming continued 4.5% annual global economic growth.

Yet the IEA expects new crude supplied by countries not in the Organization of Petroleum Exporting Countries to grow by half that amount.

Meanwhile, OPEC countries are having their own troubles. Political strife has crippled production in Nigeria. Left-wing strongman Cesar Chavez has just kicked international oil companies out of Venezuela. And we all know what's happening in Iraq.

It all adds up to a massive short- and long-term crunch, which this column highlighted back in April.

Whether or not you believe in the "peak oil" theory-that global oil production will reach a peak soon and then steadily decline-most of the world is off limits to the major oil companies, and many oil-producing countries simply don't have the infrastructure to extract and refine the oil they have. That's a recipe for a supply squeeze-and higher prices-for years to come. 

(And this is a good time for a disclosure: My wife and I own small positions in energy and commodities ETFs, which would likely benefit from higher crude prices.)

Meanwhile, in the middle of summer driving season, there's been a supply squeeze for gasoline as well, as several refineries have shut down for repairs. Retail prices for regular gas hit $3.05 this week, according to the US Department of Energy, not too far off their peak of $3.20 a gallon in May.

So, back to the original question: How high can prices go?

"It's not too hard to get to the mid-$80s based on economic fundamentals," says Mary Novak, managing director of Global Insight Energy Services in Lexington, Mass.

And Goldman Sachs, which grabbed a lot of headlines a couple of years ago for its prediction that crude could hit $105 a barrel, recently projected $90 oil by autumn and $95 by the end of the year unless OPEC loosens its production quotas.

But there's one big difference from last year when prices spiked: There's no acute crisis in the Middle East or Persian Gulf this time around.

Last summer was marked by the war between Israel and Hezbollah in Lebanon (and its smaller battles with Hamas in Gaza), while Iran's nuclear program created high anxiety and tough talk on both sides.

This year there are still internal battles in Lebanon and the Palestinian territories, but what else is new? Troubling news about al-Qaeda's resurgence and Pakistan's instability may be boosting prices a bit, but it's eerily quiet in Iran, as the unpopular regime seems preoccupied with growing domestic dissent.

Dr. Fariborz Ghadar, director of the Center for Global Business Studies at Pennsylvania State University, thinks the "fear premium [in oil prices] may be $5 to $6 a barrel" now.

And in the future? "It all depends on what happens in the Middle East," he says.

"I don't think [a military confrontation with Iran] is in the market. If that happens, we could get $100 oil for sure."

It's impossible to predict what will happen with Iran, but Professor James L. Sweeney, director of the Precourt Institute for Energy Efficiency at Stanford University, says right now traders aren't expecting the worst.

He regularly tracks options on crude oil futures traded on the New York Mercantile Exchange, and based on that says there's only a 10% probability crude will be over $100 by the end of 2009. "It's probably not going to happen," he says.

But he adds, "there's a probability of about 2/3 that oil prices will be above $60" during that time.

Considering that oil changed hands for around $10 a barrel in 1999 (when we lived in the New Economy), that suggests structurally high prices for some time to come.

And probability doesn't mean certainty, as rare events can change everything. What if there's a crisis with Iran and, say, a major hurricane around the same time?

"Then all bets are off," says Mary Novak.

Sweeney's rule of thumb is that for every $10 increase in crude prices, gasoline will rise by about 25 cents a gallon. So, if oil hits $100, that would put regular gas near $3.70.

"$100 oil will get us $4.00 a gallon gas," says Professor Ghadar.

$100 oil and $4 gas could trigger the classic 10% stock market correction so many pundits have been waiting for-and an even bigger sell-off in emerging markets. It would pinch US consumers harder, but I don't think it would tip the economy into recession.

In the meantime, I maintain my bullish outlook. But like good drivers, investors have to keep their eyes open to see what may be coming around the next corner.

Comments? Please email us at TopProsTopPicks@MoneyShow.com.

Howard R. Gold is editor-in-chief of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow.

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