Why are oil prices suddenly soaring?
The cause is the inexorable law of supply and demand. It used to be that the world had excess oil-production capacity. If prices went too high, oil-producing nations worried that the U.S. and other oil-consuming countries would go into recessionary tailspins, thus wounding the goose that lays the black-gold egg. So producers would simply pump more oil to keep prices moderate.
And because prices did remain relatively low during the late 1990s and early 2000s, there was little incentive to invest in new oil fields or increased production capacity. Many experts believed the "natural" price of oil would remain in the range of $20 to $25 per barrel.
But now the world is seeing a break from that pattern. The demand for oil is greater than expected, with continuing growth in the U.S. economy despite the energy price creep and the rapid expansion of China and other nations.
The era of higher prices is too new to have stimulated a boost in oil-production capacity, so there's no cushion. Oil producers can no longer bring prices down simply by pumping more.
And even a small disruption in the flow of oil -- anything from hurricanes and government unrest to terrorist attacks -- can cause a big spike in prices. Indeed, this latest price increase occurred after the International Energy Agency, citing shutdowns in the Gulf of Mexico and North Sea, cut its forecast of non-OPEC oil supply by about 200,000 barrels a day.
What about gas prices?
Rising prices of oil, obviously, cause gasoline prices to rise. But there are also some issues unique to gasoline. First, increased driving in the U.S. (and lower overall fleet fuel economy in recent years) is increasing demand and straining refining capacity.
Second, refiners are struggling with new questions about fuel additives. They had hoped to win liability protection in the new energy bill that President Bush signed into law on Aug. 8 for cleanups involving an additive named MTBE. But the provision was too controversial to be included. So some refiners have said that they'll stop production of gasoline with MTBE. That means additional, if temporary, constraints on gasoline supply. Supply and demand, indeed.
Is any relief in sight?
Not really. Price drops would come only through one of two ways: Either demand falls or supplies increase. Neither is likely. The U.S. economy has proved to be remarkably resilient in the face of rising oil costs -- in large part because the oil shocks of the 1970s. Back then, oil reached its all time high of about $90 per barrel, in today's dollars.
Those high prices touched off major improvements in energy efficiency, making energy costs a smaller percentage of the cost of doing business today. That development decreases the chance that soaring prices will cause a recession.
Meanwhile, economic growth in places like China is fast enough to offset the dampening effect of higher energy prices. So the demand for oil isn't likely to be reduced -- especially when Americans are driving more than ever.
Neither are supplies going to increase anytime soon. While a debate is raging about how much oil is left in the ground, today's high prices should stimulate a boom in exploration and oil-field development. That will likely get an added boost from the just-signed energy bill, which offers new incentives for expanding supply. In a few years, therefore, the world will be able to pump more oil. But that's still years away.
Another added premium in today's oil prices comes from the threat of terrorism. With production capacity already nearing its limits, an attack that cut, say, Saudi oil production would send prices soaring. That's why the price of oil is higher in the futures market than it normally would be in a calmer world, where the chances of a supply disruption are smaller.
Can the government do anything?
Not really. There will be a lot of rhetoric and hot air from Washington, including calls to release oil from the Strategic Petroleum Reserve. There will also be hyperbole claiming the new energy bill is the answer, because of its new incentives for everything from oil exploration and nuclear power to buying hybrid cars.
But these policies are effective only on the margins. The real driving force behind energy prices is simply the law of supply and demand.
But prices should moderate in a few years, right?
Probably. Until recently, many companies didn't believe prices would remain so high. So they didn't invest in new supplies or energy-efficiency measures. But now it's clear that high prices will be part of the business landscape for a long time. So there will be incentives for investing in exploration and production capacity, as well as for conservation and more efficiency.
The market does work. The longer the period of sustained high energy prices, the greater the incentive to take the steps that will eventually hold prices in check or even drop them down again. So ironically, the greater the pain now, the sooner it will come to an end.