Oil Price Soars $5 on Reduced Supply, Gas Could Head Much Higher

By , Money Morning •

By Jennifer Yousfi
Managing Editor

Crude for July delivery jumped more than $5 per barrel in New York yesterday (Wednesday) to close at $136.38 per barrel on declines in U.S. supplies and refinery activity.

Supplies fell further than expected, with a 4.56 million decline to 302.2 million barrels last week, the U.S. Energy Information Administration announced. At the same time, refineries operated at just 88.6% capacity, a decline of 1.1% from the week prior. Most analysts had expected a mean capacity increase of 0.3%, according to a
Bloomberg News survey.

"This move was sparked by the very bullish crude inventory number," Daniel Flynn, a broker with Alaron Trading Corp. in Chicago, told Bloomberg. "Falling inventories make us vulnerable to disruptions. The cheap dollar is only adding fuel to the fire."

The high cost of oil is dampening demand of already overstretched U.S. consumers. U.S. demand declined 1.3% in the four week ended June 6, the energy department said.

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However, demand is rapidly increasing in emerging markets such as China, where oil imports shot up 25% last month from the same period a year ago. Imports to the Asian nation increased to 16.2 million metric tons in May, which is about 3.8 million barrels a day, the Beijing-based Customs General Administration of China announced on its Web site yesterday.

"The big crude draw is obviously bullish, but more importantly for the oil markets, the dollar is falling and that could send us back to near $140 a barrel," Mark Waggoner, president of Excel Futures in Huntington Beach, Calif., told Reuters.

Other factors contributed to the price jump, as well. Nigeria continues to experience production problems due to attacks from the Movement for the Emancipation of the Niger Delta (MEND), which has made life particularly difficult for oil majors such as Royal Dutch Shell PLC (ADR: RDS.A, RDS.B) by bombing pipelines and kidnapping workers.

Russia, the world's second-largest oil supplier, is also experiencing problems. At a presentation in London yesterday, BP PLC (ADR: BP) Chief Executive Officer Tony Hayward said Russian output would continue to fall without changes to the current tax policy of the Russian government.

"Russian authorities are responding" with fiscal regime changes, though it may take "a couple of years to reverse the current trend," Hayward said.

High Oil, High Gas, Weak Economy

If oil stays near $140 per barrel, gas prices could easily top $4.75 a gallon by the Fourth of July holiday, Mark Zandi, chief economist at Moody's Economy.com (MCO), said in a recent research note.

And while the thought of gas at almost $5 per gallon is distressing enough, Money Morning's Investment Director Keith Fitz-Gerald thinks gas prices could go even higher. In fact, U.S. motorists could easily be looking at $7 a gallon gasoline within just two years. And that could have a disastrous impact on the U.S. economy.

"The bottom line is that the effect on the economy is going to be a lot worse than anyone's talking about right now," said Fitz-Gerald, a longtime energy bull who recently boosted his oil-price projection to $225 a barrel. "The bottom line is this: Until someone develops a truly [interchangeable] alternative for oil and gasoline - something that works the same, costs the same and is just as effective - Americans are just going to have to face the fact that over time they're going to pay more."

By fixating on near-term prices, and near-term fallout, Fitz-Gerald says that investors and economists alike are missing the bigger point: Long-term - or at least until a true replacement for oil is found - the U.S. economy is going to be badly stung, and U.S. consumers who don't take steps to protect themselves are looking at a markedly reduced standard of living.

Moody's Economy.com's Mark Zandi agrees.

"Unless oil prices soon recede and Washington changes its views and acts to shore up the housing market and broader economy, the outlook for 2009 will weaken further in coming months," Zandi said.

Zandi added that the U.S. Federal Reserve "will sacrifice near-term growth for the sake of stable prices and the economy's longer-term prospects" and that the high cost of oil will prevent any further interest rate cuts.

But don't look for gas prices to move up in a straight line to $5, $6 and $7 a gallon, Fitz-Gerald says. Prices will continue to fluctuate. There will be rallies, and retrenchments, as is the case with the price of any commodity.

But prices will rise, as there is still no truly "fungible" - interchangeable - replacement for petroleum. That's what's needed, Fitz-Gerald says.

In the interim, investors should: be "long" on oil and other commodities; have alternative-energy-related investments; and look for profit plays in ancillary sectors, Fitz-Gerald says.

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