Gas Prices Are Rising, But Don't Fear Last Year's Shock

Oil prices headed higher this week, causing many consumers to wonder whether we're in for a replay of last year's sky high gasoline prices. While it's true that oil prices have climbed considerably from their lows earlier this year, it's unlikely that we will have a rerun of last year's pain at the pump.

Higher gasoline prices tend to be caused by a couple of key factors: strong demand in the economy and speculative investors buying oil as a hedge against a lower dollar.

While some economists have said they see "green shoots" begin to emerge, the economy is still far from recovery. Exxon chief executive Rex Tillerson told reporters earlier this week that oil market fundamentals haven't changed much since the beginning of the year. He said there has been no significant change in demand and there was a large overhang of inventories. In other words, supply still exceeds demand, putting downward pressure on prices.

That view was challenged by new data released today by the Department of Energy, which showed demand was much stronger than expected. Crude oil stockpiles dropped 5.1 million barrels, compared to an average forecast of 500,000. Ten times more demand than was expected! Some economists saw that as a sign that U.S. refineries were getting back to work after the winter downturn.

But that still doesn't mean gas prices, now hovering around $2.40 a gallon, will shoot up to the average $4 a gallon prices we saw last summer.

The reason is that the oil price is controlled to a large extent by the Organization of Petroleum Exporting Countries, which supplies about 40 percent of global oil production. OPEC has cut 4.2 million barrels a day of production since last year, in a successful bid to support the oil price.

While OPEC is nudging prices above $65 a barrel -- up from $34 just three months ago -- it is sitting on six million barrels a day of spare capacity. Analysts at Bank of America say that "given the precarious state of the global economy, it makes sense to us to expect that Saudi Arabia would boost production if prices moved up too quickly." The B of A analysts said that line was probably $80 a barrel.

At a meeting of OPEC today, Saudi Arabia's oil minister Ali al-Naimi said the current market contained positive signs. "The price is good, the market is in good shape , recovery is under way. What else could we want?" al-Naimi said.

Still, even slightly higher prices can hurt an economy. One analyst predicts that if oil prices stay above $65 a barrel over the summer, it could cause several U.S. air carriers to lose money.
In addition to OPEC's support for the oil price, there is also speculative interest in investing in petroleum. According to BusinessWeek, $4.3 billion has flowed into exchange-traded oil and gas funds since the beginning of the year.

For some investors, it was an opportunity to lock in the low prices that prevailed in February. But for others, buying oil is a hedge against a cheaper dollar. Oil prices often move in the opposite direction of the dollar. Since the dollar has declined about 10 percent since the beginning of the year, prices for oil and other commodities have moved in the opposite direction.

It was these speculative investments that caused the oil price to spike last summer. But with oil producers such as Saudi Arabia prepared to intervene to keep prices from rising too quickly, there is little reason to fear a return to last year's gas pump shock.