Oil Prices Will Tank

This guy must be brilliant because he agrees with me.

The oil bulls are correct in their explanations of why prices have jumped. It's indisputable that worldwide demand has surged, chiefly driven by strong growth in China, India and the Middle East. It's also true that most of the world's reserves are controlled by governments in places like Russia and Venezuela that mismanage production, thus curtailing supply growth.

But rather than forming a permanent new plateau for prices - as the bulls contend - those forces are causing a classically unstable market that's destined for a steep fall.

In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.

So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."

But today, the sudden surge in demand and the production bottlenecks have thrown the market radically out of balance.

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The author then goes into an explanation of the housing bubble leading to:

The story is much the same with oil, with a twist. A big swath of the market isn't really paying that $125 a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.

But sooner or later the world won't keep paying those prices: Eventually, the price must fall back to the cost of that last barrel to clear the market.

So what does that barrel cost today? According to Stephen Brown, an economist at the Dallas Federal Reserve, that final barrel costs just $50 to produce. And when the price is $125, the incentive to pour out more oil, like homebuilders' incentive to build more two years ago, is irresistible.

It takes a while to develop new supplies of oil, but the signs of a surge are already in place. Shale oil costing around $70 a barrel is now being produced in the Dakotas. Tar sands are attracting investment in Canada, also at around $70. New technology could soon minimize the pollution caused by producing oil from our super-plentiful supplies of coal.

"History suggests that when there's this much money to be made, new supplies do get developed," says Brown.

That's just the supply side of the equation. Demand should start to decline as well, albeit gradually.

And that my friends will lead to a a pop of the oil market bubble. When it does it will probably be severe leading to sub $50/bbl prices, we just need to hope that by that time alternative sources remain cheap enough to be competitive.