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Why Oil Prices Are So Volatile

Over the past two years, the price you've paid for a gallon of gas has ranged from an average of $1.60 to $4.11. To use an economic term, that's nuts. While the Arab oil embargo, the Iranian revolution, and the Gulf War, not surprisingly, provoked big price jumps at the pump, not one of those events caused a two-year round trip as dramatic as the one we've just seen. And the geopolitical drama that caused the most recent spike, sending the price of a barrel of crude up to $145 on July 4, 2008? Well, there wasn't one. So why did gas prices leap 100 percent in 12 months only to plummet to $30 on December 23, and then more than double, to a recent peak of almost $75 on August 21? And how much will it cost you to fill up your tank in the coming years?

Crude Oil Prices 2000-Present

What’s Driving Prices

There are four major factors that determine oil prices — supply, consumption, financial markets, and government policies. What has happened is that what have historically been the fundamental factors in pricing the barrel — supply and consumption — are no longer in the driver’s seat. So this year, for example, there has been abundant supply and slowing demand, but prices have doubled. Economics 101 says that shouldn’t happen. But it has.

“In today’s world, oil-price dynamics are different than even 10 years ago,” says Kenneth Medlock, an energy economist at the Baker Institute at Rice University in Houston.

Prices are not just curious; they are wild. From 1999 to 2004, the biggest difference between the high and low price in any given year was $16; from 2005 on, the average variance was $52 — but in 2008 it was $115. Oil, of course, is not the only commodity that has been frisky; copper has been even more so this year, and everything from onions to equities has seen massive price swings. At the same time, investment in commodity indexes, which are heavily weighted in oil, has risen sharply, from about $15 billion in 2003 to $200 billion last year.

And, yes, there is a relationship between increased investment and increased volatility, so speculators are indeed making a big difference in the oil market, something that has riled up politicians here and in Europe, who are concerned that high oil prices could hurt their countries’ economic recoveries. In late July, the U.S. Commodity Futures Trading Commission held hearings on what, if anything, to do about that. The CFTC is considering new rules for the oil markets.

But before you go out and demand your Congressman ship all those speculators to an oil rig in Siberia, remember that speculation is an essential part of any financial market; the purchase of any stock, for example, is really an act of speculation on the future prospects of the company. And a larger point is that, like any market, oil operates in a context.

The Bigger Picture

One reason prices have been rising so strongly this year, for example, is that futures traders are doing what they are supposed to do — anticipating. Just as stock prices anticipate future returns, so do commodity prices. Specifically, traders are betting that the global economy will recover later this year, and that the supplies will therefore tighten. There is good reason to believe this is correct; world oil production last year was barely above 2004 levels, and there is little chance it is going to shoot up. Rather the opposite: Daniel Yergin, author of The Prize: The Epic Quest for Oil, Money and Power, and head of IHS/CERA, an energy consultancy, told Newsweek in early July that “of the 15 million barrels of new net capacity that was supposed to come online between 2008 and 2014, over half of it is at risk of not happening.” Investment in new fields has not been robust; when the current overcapacity is sucked up, the gap between supply and consumption will narrow again, forcing prices up.

On that thinking, $75 per barrel can look like a good bet. “Over the last six months, crude-oil futures have been a proxy on economic growth six months out,” concludes Tom Kloza, publisher of Oil Price Information Service, a newsletter that tracks the oil market. “You can read the sentiment swings out there.”

OK, but what about the really speculative speculation, such as the hedge funds, money managers, and banks that have gone into commodities big-time? Looking back, it seems almost certain that traders chasing paper profits drove some of last year’s frenzy; $145 oil at a time of soft demand and ample supply was “nuts, absolutely,” says Medlock. “Speculators can influence price beyond the fundamentals. When a majority of players don’t have a physical stake, they trade on technical indicators — psychological numbers. Quite frankly, that is nonsense in a physical market.”

So why oil? Why not something else? Again, think context. Oil is globally traded, dollar denominated, and there is a lot of it. What has happened is that it has become, in effect, a financial instrument, being used as a hedge against both a falling dollar and inflation. If the dollar weakens, a trader can make money just by keeping the rights to a barrel and selling it as the greenback sinks. Before 2002, there was a weak correlation between the value of the dollar and the price of oil, but since then, the correlation has been strong. “Oil is the antidollar, even more than gold,” says Sean Brodrick, a natural resources analyst at Weiss Research in Jupiter, Florida. “I literally see this relationship on the screens — out of the dollar into oil, back and forth.”

Then there is the fear of inflation. Date this back to the dot-com stock-market crash of 2000-01 and subsequent aggressive easing of monetary policy by the Fed. Concerned by the inflationary potential, money managers began to hold bigger commodity positions. Now consider the big spending increases by the Bush administration, plus the hugely expansionary nature of the Obama administration’s bailout and fiscal policies, combined with historically low interest rates. For those who think all this will be inflationary, the demand for oil and other commodities is going to be strong.

What to Do About It

Given that speculation is one of the villains in volatility, the natural political temptation is to whiplash the oil traders. And naturally, the traders are against any new restrictions, arguing that they provide necessary liquidity to the markets, allowing end users like airlines to hedge. The thing is, the latter seem to be ungrateful for the favor. The Air Transport Association denounced the “destructive volatility in oil markets” at the CFTC hearings on July 28; Delta Airlines (DAL) estimated the 2007-08 oil bubble cost it $8.4 billion. Consequently, “position limits” that restrict the number of contracts traders can hold are likely, as are increases in margin requirements and new requirements to reveal who is trading what and when.

But this will not be enough. Volatility is likely when there is a tight fit between supply and demand. So the U.S. could also try to create a little more breathing room by reducing its consumption of oil and boosting its own production. The one and only certain way to reduce consumption is to raise prices; from November 2007 to October 2008, during the course of the Big Price Run-up, Americans drove 100 billion fewer miles than the year before. You won’t hear this on Capitol Hill, home to the illusion that conservation and cheap gas can occur simultaneously, but a higher tax on gas could help to stabilize prices. So could opening up more territory for drilling. And so would some assurance that there is a plan to finance government spending without simply printing money.

Where Will Prices Go From Here?

Oil-price forecasting is not for the humble. The oil market has often made very smart people look pretty stupid. And it is common for several smart people to look at the exact same data and then arrive at opposite conclusions. Right now, for example, Philip Verleger, a Colorado-based oil-price analyst, is predicting that prices could dip to the $20 range this year; Goldman Sachs, meanwhile, puts the figure at $85, considerably more than its December guess of $45, but well below its May 2008 prediction of a spike to $200. T. Boone Pickens estimates a 2009 average price of $75 and Morgan Stanley, $60.

But over the long term, there is something akin to consensus that the days of cheap oil that characterized most of the 20th century are gone. While new CFTC regulations might cool some of the hottest money — and that is anything but certain, if the oil markets in London, Dubai, and elsewhere do not follow suit — all the other factors argue for higher prices. China and India’s desire for oil will only grow, and when the economic recovery comes, consumption will also rise in the U.S. and Europe. And the drop-off in investment means that once the current overhang is sucked up, demand will rise faster than supply. In this case, Econ 101 does apply: Prices will go up.

Moreover, the regulatory environment will also push up prices. New rules on sulfur content, for example, will raise demand for sweet crude, which is not as abundant as other kinds of oil. Climate-change legislation could also increase the price of fossil fuels. In the medium and long term, all indicators point to more expensive energy.

Wise consumers, then, will act as if prices have already risen, buying more fuel-efficient cars, shifting away from heating oil, and taking commuting distance into account when eyeing real estate. And it can’t hurt to have some exposure to energy in your portfolio — if you have to pay four or five bucks for a gallon of gas, it might offer some comfort to know you’re paying yourself a nice dividend. You might as well get used to it, because $2.50 gas will not be with us for long.

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