Brave New World

Story Highlights:

• Some believe a global economic slowdown will reduce demand for oil, ultimately leading to lower prices.
• It's important to distinguish slowing economic growth from contraction. Slow economic growth is still growth—and given the lack of energy options available, demand for oil will likely stay high.
• As long as demand stays high, prices will too.
• High or low, always remember oil prices and stock market moves are largely non-correlated.

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Aldous Huxley's satire of the popular utopian novels of the Roaring Twenties may seem apropos today. Oil prices are soaring, conjuring up worries of runaway inflation and frightening visions of the future. But some people are actually betting on a reversal of prices, shorting oil lately. (Their rush to cover these short positions likely contributed to the surge in prices on Friday. See our 6/6 cover story, "Freaky Friday," for more.) Many who predict lower oil are betting a slowdown in the global economy will lead to reduced demand and, ultimately, lower prices. But there are many reasons to believe high oil prices are here to stay.

There doesn't appear to be a large-scale alternative to crude oil waiting in the wings. Energy substitutions historically take a long time—the fastest was probably the conversion from wood to coal, which took about 75 years. The more recent change from coal to oil took 100 years—from about 1860 to 1960. And one could argue kicking the habit for crude oil will be especially difficult due to the lack of recent innovation in finding alternatives. Though advances in renewable sources like wind, solar and geothermal options are notable, none are scalable enough to replace a vast energy source like crude oil. In fact, the only large-scale potential replacement introduced over the past 100 years is nuclear power.

Moreover, because many of the fastest-growing economies (those in emerging markets—especially China) use energy relatively inefficiently, it's unlikely the efficiency gains in Europe and Japan can offset increases in worldwide demand. And bringing new crude online from discovery to production takes years, so don't expect a price-squelching glut of supply anytime soon. As long as oil prices remain high, incentives to create new energy sources and / or improve oil efficiency abound—but there's no reason to expect an overnight solution. For a while at least, crude oil will remain the energy source of choice.

Those who point to a slowing global economy as a reason for falling oil prices (due to reduced demand) are likely to be disappointed. Why? The world economy is still growing. There's a key distinction between a slowing rate of economic growth (say from positive 5% to positive 3%) and actual contraction. A contraction is a shrinking economy, or negative growth. Contrary to what headlines suggest, though the US economy's growth rate has slowed (especially relative to other parts of the world), it hasn't posted a single quarter of negative GDP in this economic cycle.

And the US is only 25% of the global economy. Even with modest and, in some cases, negative expectations for US growth, consensus forecasts for global growth remain nicely positive this year, not negative. Because a reduction in demand for oil (barring increased efficiencies or new energy supply) would require a significant economic contraction, not just a slowing economy or even a mild recession, oil prices are likely to stay firm.

That's not to say prices can't fluctuate wildly in the short-term—up or down. It's certainly possible speculation-driven demand is pushing prices around day-to-day. But over time, fundamentals should trump things like short-term supply interruptions or investor psychology.

So are we headed for a futuristic collapse of sci-fi proportions? Not likely. In some ways, we should welcome high oil prices as a sign of economic health—oil's been on the rise for some years, in tandem with a robust global economy, limited new supply and, surprisingly to some, a continued bull market for stocks. Contrary to popular belief, oil prices and stock prices aren't meaningfully correlated. See our 06/02 cover story, "Oil!" for more. And remember energy consumption is still a modest component of both personal spending and GDP in the US. Though high oil prices are a painful reality today, increases for oil have generally been offset by increases in personal income and decreases in other prices, keeping inflation largely in check. So be brave. The new world we live in may not be a utopia, but it's not a dystopia either.