Gasoline and the rule of 72

Gasoline has hit $3.40 a gallon in Saint Paul, MN. It's $3.60 in Chicago. These numbers don't get all that much attention nowadays. It's much less than the price in most of the industrialized world of course (lower taxes here), and gas is probably still relatively cheap by historic standards. The price will doubtless decrease in the fall.

Still, it's an opportunity to reflect on the economics of oil and gasoline. Imagine that you were in the petroleum business and that your horizon for investment decisions was 10 years. Imagine (now don't faint!) that you were more than 90% confident that the price of gasoline in 9 years would be, assuming no changes in taxes, $28 a gallon.

That's a doubling every 3 years, and by the "rule of 72" that's a 24% rate of annual compounding (72/3=24). Wow. That's a fantastic rate of return. You could just borrow money at 8% to keep your business going, store the oil in the ground, and then sell it later. The 16% difference is a great way to run a business.

That's outrageous of course. Almost nobody expects gasoline to sell for almost $30 a gallon by 2016.

Still. There's some smaller rate of return that would make retaining rather than selling petroleum products the right way to invest. This is what all the "peak oil" crowd get excited about; but the term is a bit misleading. It's not that oil production needs to peak, it's simply that demand has to persistently outstrip supply. Prices, of course, don't wait for demand to outstrip supply, they begin rising as soon as a demand/supply gap can be reasonably anticipated within the time frame of investment decisions (10 years roughly).

This, by the way, is a very good thing. It means that prices rise long before we run out of oil, giving everyone time to adapt and adjust.

I do wonder what the sober experts calculate. They can look at supply curves and demand curves and the available substitutions within the next decade. Do they see a significant supply/demand gap opening up? If the price of gas will be $7/gallon in six years (well within the lifespan of your next Ford F-250), is that enough of rate of return to justify holding products now?

I wish Brad DeLong would say something about this.