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Here's Why Oil Is So Expensive

United Parcel Service (UPS - Get Report) and FedEx (FDX) are both using -- and have announced plans to continue to use -- natural gas as a replacement for diesel fuels.

While it's true it will take time for demand to shift from diesel to natural gas, two important facts need to be understood. First, the market is a forward-discounting mechanism and prices will tend to reflect what the market believes they should be in six to 12 months into the future.

Second, diesel shouldn't be expected to drop 3% if demand moves lower by 3%. There is not a linear relationship between the supply and demand curve. A 3% reduction in demand is likely to result in a 6%-10% drop in price.

While it's possible for natural gas and diesel to reach cost-per-mile parity, I would not expect it to happen anytime soon. Natural gas engines are currently more expensive and it's much harder to travel with the lack of refueling stations.

China

Whether using natural gas or diesel engines in automobiles, China has now become the largest auto market in the world and it may be hard to make an argument that China's energy consumption is going to take a significant downward turn anytime soon.

China's growing energy demand growth should not be considered the same as European or American growth. Between domestic and foreign sources, China can be expected to maintain a healthy balance between needs and sources.

China National Offshore, China National Petroleum and Sinopec do not have the same inconveniences securing energy as American and most European companies have. Take Iran, for example. While U.S. politicians are spending time trying to figure out ways to make Iran do what it says, China is inking deals and promoting good will.

It would appear Europe is also playing the "do what we say" game, and it remains to be seen who will win. In the meantime, China appears to be the biggest winner. What Europeans pay in increased energy prices , China receives for less.

Don't expect a "Foreign Corrupt Practices Act" and other distractions designed to prevent bribery or anything else getting in the way of China's appetite for energy. The net result is, China can be expected to aid in the world production supply in relation to world energy prices. If you believe China is going to drive oil up to $200 a barrel, you should not count on it.

End result: Expect that Europe, in general, will not drive prices higher; China will mitigate price movements; and the U.S. will increase in production to drive prices lower.

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