A wide gap has emerged between the factors that are driving the run-up in oil prices – strife in the Middle East, rising demand in Asia, a weakening dollar – and the solutions that politicians in Washington are currently offering to ease pain at the pump. Focusing on the effect of speculation and domestic production on crude prices is comfortable for policy-makers, but doing so distracts from the real challenges that the US and other countries will face in the long term. In today’s Energy and Climate Brief, Garten Rothkopf examines what is behind the recent rise in oil prices, as well as how the responses of policymakers have largely avoided fundamentals in favor of relatively marginal factors.

As gasoline prices surge higher, politicians on both sides of the aisle are dusting off familiar arguments to gain political advantage from $4 a gallon gas; what is lacking is a real accounting with the fundamentals of oil prices as well as the lessons of previous price shocks. With politicians blaming a lack of domestic production, speculators, or price gouging, what lessons can we learn that might be relevant today by systematically looking back at the 2008 price spike?  The first is that supply constraints, long-term demand growth and inelasticity, and the plunging value of the dollar all played critical roles in causing the price spike last time. These same conditions are present to varying degrees again in 2011, but there have also been shifts in terms of capacity (increased) and global demand (not as high). Today’s GR Energy and Climate Brief looks to the last crisis for lessons on the real vs. imagined causes of the price spikes and the implications of those lessons on the blame game currently raging in Washington.

Consider the Fundamentals

In mid-2008, worldwide excess capacity stood at less than 2 million bpd. As tight inventory during the last spike helped to push up prices, demand showed no signs of slowing – it was not until prices hit $140 that demand began to show elasticity. While supply and demand alone certainly couldn’t explain the pace or amplitude of the oil price spike in 2008, they were working strongly in its favor. Today, while developed nations are still emerging sluggishly from the downturn, oil demand among the largest emerging markets remains strong. What is different today is that there is significantly more spare capacity; according to US Energy Secretary Stephen Chu, global spare capacity today stands at nearly four million barrels per day. At his first-ever press conference yesterday, US Federal Reserve Board Chairman Ben Bernanke said he still plans to keep interest rates low, which investors equate with a continued weaker US dollar, and attributed the recent developments in the Middle East to the significant increase in gas prices in the United States, but also to the increasing demand for oil from emerging markets. "In the United States, our demand for oil, our imports have actually been going down over time. So the demand is coming from a growing economy, where we've seen about a 25 per cent increase in emerging market output... since before the [economic] crisis," Bernanke noted.

The critical fundamental in the market today is that the markets are pricing in the risk of instability in the Middle East.  “At this juncture, the markets are telling us there is higher risk, in the neighborhood of $20. They are watching currencies, gold, and the price of oil. They are paying attention to geopolitical risk. After that, you pay your money and you take your changes,” Hugh Johnson, chief investment officer of Hugh Johnson Advisers in Albany, New York, said. 

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