Oil Prices: How High Can They Go?

Crude prices are hitting new highs, and it's easy to see why: Demand is still roaring, and spare capacity is scarce

Like baseball and real estate, complaining about energy prices is a national pastime. And while high gasoline prices can certainly make trips to the pump painful, they do not appear to have visited major havoc on the U.S. economy—yet. That may have offered some small comfort of late to motorists shelling out more than $60 to fill up their Escalades.

But the comfort zone may be shrinking fast. On July 7, August futures for light sweet crude brushed a record $75.78 per barrel in electronic trading on the NYMEX amid saber rattling from Iran and North Korea. Although prices eased later in the day, the fresh strength may signal that elevated energy costs could be a fact of life in America for the foreseeable future.


  Phil Flynn, an analyst and trader at the Chicago futures brokerage Alaron, says that oil prices have been rising about $10 per barrel annually. "As long as the economy continues to expand, we will be at $80" next year, he predicts. For the most part, he says the growing economy has kept pace with or outpaced the price of oil. Energy prices have "slowed the economy a bit but really haven't stopped it."

It's certainly clear that high oil prices aren't dulling demand for energy products. According to the Energy Dept.'s Energy Information Administration (EIA), U.S. demand for gasoline in June was 9.5 million barrels per day, a record.

Like Flynn, Standard & Poor's Chief Economist David Wyss points out that rising gas prices have not had a massive impact on the economy as a whole. He notes, however, that the $3.00-plus per gallon price tag has been harder on consumers. Gas prices have "wiped out the increase in wages over the past 12 months."

And the pinch could get more severe in the current economic "softening," Wyss says, not to mention if the dollar declines further against world currencies. He expects oil prices will hit $80 per barrel, though he declines to predict exactly when.


  If these trends continue, Wyss and Flynn agree that the current supply-demand situation alone won't cause a drastic economic problem. Certain scenarios could make it much worse. Wyss says that if the U.S. were to go to war with oil-rich Iran, the resulting disruption to world petroleum markets could cause the price of oil to double.

It's no mystery why oil prices are rising. Doug MacIntyre, a senior analyst at the EIA, says that worldwide spare production capacity is between 1 million and 1.5 million barrels of oil a day, less than Iran produces, and down from about 5.5 million barrels of spare capacity in 2002.

More spare capacity will likely arise as new reserves come online and demand slackens, but MacIntyre says the EIA, like most observers, projects that markets will remain very tight through 2007. That means gas prices will stay high, too. A host of factors contribute to the pump price, but a $1 rise per barrel of crude translates into about a 2.4-cent rise per gallon of gas.


  And political tensions in oil-producing states like Nigeria and Venezuela could exacerbate the problem. Strong global economic growth also tightens supply, especially in growing economies like India and China.

Switching gears from politics to nature, markets are also tense about the hurricane season. During last year's vicious season there were days when the Gulf of Mexico's 1.5 million-barrel-per-day capacity was basically lost, and some damage lasted for months. Another big storm in the Gulf this year could have an equally devastating impact. "There's your spare production capacity, gone like that," MacIntyre says, referring to the global industry.

One minor positive is that MacIntyre says supplies of heating oil for next winter look relatively "flush," mitigating the chance of further increases as the cold season approaches. He cautions, however, that it's too early to be conclusive; demand is closely tied to weather conditions.

With so many potential variables there's little choice for consumers but to ride it out and hope gas prices don't climb higher. "Given that we still don't have a realistic energy policy in this country, we don't have a lot of insulation," Wyss says.

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