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CNBC Contributor Farrell: Why The Price Of Oil Will Correct

Monday, 19 May 2008 | 10:21 AM ET

As oil heads towards $130 per barrel, Scotsman Capital managing director Vince Farrell, a CNBC contributor, shared his thoughts on why he thinks the price will correct. The following comments are his.

"The price of oil seems unable to go down. Despite sky high prices and a clear slowdown in consumer spending and in consumer confidence, oil forges ahead. The reasons are several, although I think the price is ahead of the fundamentals and will correct.

Over 80% of the world's oil reserves are owned by sovereign nations or national oil companies and ,as a rule, they don't like us, and they see their oil reserves as a national resource to be husbanded correctly. OPEC is producing at just shy of maximum capacity and the Saudi's, for example, are employing three times the drilling rigs as usual and their productive capacity has not increased much, if at all.

That is a clear sign their major field, Ghawar, which pumps more than 50% of the Saudi total production, is in decline. Non- OPEC production has declined several years in a row and the chaos in countries like Venezuela and Nigeria doesn't hold out hope for better production tomorrow. Mexico, not an OPEC member, will soon be an importer of oil. The North Sea and the North Slope of Alaska have been in decline for a while and no new large finds have occurred.

Demand seems to grow despite the price rise. In the U.S., 70% of the cost of goods sold is labor so oil doesn't have the same impact as several decades ago when oil was last near this level. The American consumer is reluctant to give up his lifestyle and the demand from emerging nations like India and China keeps rising.

But the solution for a high oil price is, oddly, a high price, which at some point will bring about demand destruction. It could be $4.00 gas will be the tipping point. Total world wide consumption is about 87 million barrels a day and productive capacity is about 89 million barrels.

There usually has to be at least a 5% spread for prices to stabilize. This would argue for prices to continue to rise. My guess is with a slower world economy, oil will lose some of its speculative allure. If the dollar were to strengthen, oil would decline as oil is priced in dollars. With the Fed apparently finished cutting interest rates, the dollar might just rally.

There are several conservation measures that make some common sense. If we were to accelerate slowly (whatever that may mean) at today's price of gas, the average consumer would save $250 a year. If we all drove 10 miles slower on the highway, not 55 miles per hour, just 10 miles per hour slower, we would in effect save .30 a gallon. We also throw away wood and paper annually that if recycled would heat 50 million homes.

Wind, solar and nuclear are the answers to the issue of trying to be energy independent, but they are not short term solutions. Actually, there are no short term solutions other than a BIG recession and I would rather complain about the price at the pump."

Questions? Comments? marketinsider@cnbc.com

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