Model Portfolio timbo56:SSOF1

No, I don't mean that these comments will be stupid. I'd like to react to some comments in today's New York Times Business Section from the the "Market Maker" column by Nelson D. Schwartz bearing the headline "A Peak Behind the Price at the Pump." The first comment is that of Mr. Schwartz who writes, "While no one disputes that China and other emerging economies are craving more crude, the stunning rise of oil from $62 a a year ago is hard to explain as only a matter of supply and demand. After all, analysts have noted adequate inventories." Excuse me??? If the price rises to a point higher than supply and demand would dictate, then inventories should rather quickly become more than adequate. The higher price should restrain demand and increase supply, causing inventories to become bloated. This is what happened in the summer of 2006, when prices rose to the high $70s per barrel. The fact that U.S. inventories, as reported by the Energy Information Agency of the Department of Energy (http://eia.doe.gov) are slightly lower now then at the same time last year indicates that prices have not, for the most part, been above the point that supply and demand dictates. The most recent rise to levels in the mid 120's is too recent to evaluate, however. If, in a few weeks inventories rise above the levels of a year ago it could well be an indication that the price has risen too high and is due to fall. One thing that I feel certain of is that these prices will severely cut into demand. Yes, demand for oil is price inelastic, but not completely so. There is elasticity there. And we are seeing it and will see more of it.

The second statement is an implied quote from one William H. Brown III, an independent energy consultant in Chappaqua, New York, "Based on more traditional fundamentals like the cost of finding, producing and shipping crude, oil should be in the mid-60s." Excuse me!!!????!!!! If we spend $X to find, develop and produce Y barrels of oil, and if X/Y = $60/barrel that does not, does not, does not mean that if we spent $2X we would find, develop and produce 2Y barrels. Even if the additional $X could be spent efficiently, that oil drilling rigs would pop into existence at the right price and that trained workers would materialize and could be hired at the same rate as if we were spending only the original $X rather than $2X, it still would not mean that 2Y barrels would be found, developed and produced. This is because at any one time, there are only a certain number of good prospects for exploration and development. So saying that a cost of $60 per barrel to find, produce and ship oil should set the price at $60 barrel is a little like saying that if it costs X amount to produce a bushel of corn, that should set the price of corn. If the price goes above X, farmers should just increase their expenditures per acre and grow more corn. WELL IT DOES NOT WORK THAT WAY. It's possible that even if a farmer doubled his expenditures he would not grow a single additional ear because he is already spending all the money that can sensibly be spent to grow the maximum amount of corn on his land. And it's possible that if we doubled our expenditures for finding and producing oil, we would not find and produce very much more oil at all, because we are already spending all the money that can be sensibly spent on those efforts.

None of this is to say that the basic point of the column, that some of the price increase in crude is due to dollar hedging is perhaps not correct. But wouldn't one expect to see a little more of that hedge money going into gold, rather than oil. For my money, basic supply and demand has been the principal driver of the increase in oil prices, with other factors playing supporting roles. Sure, it may have run up a bit too high. What we have seen over the last few years is an oscillation about a rising mean, and we could be at the high point of an oscillation. But the mean has been rising because of supply and demand, and that is not about to stop.