Oil

There are many who think that the demand for oil is an indicator of the health of the economy. This was a reasonable link in prior years but following the tremendous increase in oil prices a year ago, I believe there has been a fundamental change in the way Americans will use foreign oil.

Americans have started to drive less, use more energy efficient products and start to increase the use of domestic and renewable resources. Now, these changes are not going to look very dramatic. However, you have to realize that an awful lot of economic impacts are at the margins. Often the bulk of data is in fact relatively irrelevant to price changes, it is the rate of change or marginal data that has an impact.

Consider a basic supply and demand scenario. If the supply of an item is at 100 and the demand is also at 100, you have equilibrium. At that level there will be a price set. Now if you reduce the demand by 5%, meaning that 95% of the demand stays unchanged, you go into an oversupply situation. This will lead to a reduction in prices and the theory says that the price decrease will either increase demand or drive suppliers out of the market until we reach a new equilibrium.

The market reacts to these marginal changes depending upon the elasticity of supply and demand. Now, to expand a bit on the theory, you have to consider cyclical demand swings versus secular demand swings. Cyclical demand goes up and down based on relatively short term economic conditions. Those who are linking oil to economic health are using it as a cyclical indicator and it certainly is to some extent. However, if I am right and the secular forces are pointing to a long term decrease in oil use, the cyclical increase will be blunted by the secular decrease.

Now, the question that has to be addressed is whether the secular trend is strong enough to overcome short term cyclical demand. Of course we also are seeing increases in cyclical supply and I believe a misguided secular increase in supply as technology shows new potential oil sources.