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 September 21, 2007
The Reasons Behind Oil's Sudden Spike

 (By Marianne Lavelle) - A funny thing happened to crude oil while the eyes of the business world were on the Federal Reserve and whether Ben Bernanke and company would cut short-term interest rates to stave off a recession. The price of oil climbed in the days leading up to the Fed's interest rate cut and then climbed some more afterward, so it now tops $83 per barrel. That might seem a strange development, especially with the economy weak enough to prompt such forceful Fed action. A slowdown usually means less demand for oil, and lower prices. Here's a primer on what's happening with oil, some best guesses on why, and how it's bound to affect you.

Is this the highest price we've ever seen for oil?

You bet, at least if you just look at the number on the barrel, so to speak. That price tag hit a record in seven straight sessions at the New York Mercantile Exchange, the futures market where oil is bought and sold. But if you look back 26 years to the crisis caused by the Iran-Iraq War, the price of oil reached the equivalent of $92.91 in today's dollars, even though the price tag on the January 1981 barrel read $38.85. So we have higher to go to get to a true inflation-adjusted record. But with the price up a full 33 percent over a year ago, it still seems pretty darn pricey.

But why haven't I seen the price rising at the gas pump?

Just wait. It's likely you will see rising gas prices in the next couple of weeks, since about 53 percent of the cost of a gallon of gasoline is a pass-through of crude oil costs. But government energy watchers actually recorded a 3.1 cent drop in the nation's average price of gasoline (to $2.79 per gallon) the same week that crude oil was soaring on the futures market. Through the spring and early summer of this year, gasoline prices did rise faster than crude prices because of fires and other major problems with the aged and creaky U.S. refining system. But refineries are not under as much pressure after summer driving season ends, so even though they still are running at nearly full capacity, they aren't the source of the problems now roiling the market.

So what is to blame for the soaring price of oil?

Government forecasters will be quick to point to market fundamentals, the rising global demand for oil--particularly from the booming Asian economies--and the fairly low "surplus capacity." That means the system has little ability to churn out a great deal more than it already is supplying. Hence no one in the oil markets really believed it on September 11 of this year when the Organization of Petroleum Exporting Countries reversed its recently held "stay the course" stance and said it would increase production this fall. Also not helping: rising international tensions over Iran's nuclear program and Iraq involvement, with new French President Nicolas Sarkozy driving war speculation.

But there's nothing new about Asian demand for oil and Middle East tension. Why $80 oil now?

A lot of market watchers are stumped, as well. Shell's chief executive recently chalked it up to "a lot of psychology," while Exxon's top dog said simply, "There is something else going on that I don't get."

Some observers have blamed the weak dollar, which has fallen to a record low against the euro, making oil futures cheaper for foreign investors. Still others think that explanation misses a more profound link between the weak dollar and high oil prices: The commodity markets are betting on rising inflation ahead.

By that thinking, it's no coincidence that the price of gold rose to a 27-year high along with the rise in the price of Black Gold. Investors are buying those commodities as hedges against inflation. "I don't think this is being driven by traditional supply-and-demand fundamentals," says Bill O'Grady, global analyst for A.G. Edwards & Sons. "This is money looking to place itself. And if central bankers are willing to risk inflation to protect the economy from recession, the correct way to do that is to own commodities and foreign currencies."

But all these people buying oil--where do they put it?

These investors aren't really taking delivery of that oil. They're buying futures contracts that they intend to sell at an even higher price. Speculators and energy companies alike buy and sell these contracts on the futures market; in recent years, the amount of money from investors--as opposed to those who actually want to take delivery of the product--has risen substantially. That's because there are more vehicles for investors like the investment funds that track the S&P GSCI (formerly known as the Goldman Sachs commodities index before it was sold to Standard & Poor's earlier this year).