Why oil is so expensive

Don't blame OPEC. The major factors are a weak dollar and speculation.

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For years, the Organization of the Petroleum Exporting Countries (OPEC) has argued that oil prices are being driven by external factors such as the weakening dollar and speculators – and are thus out of the cartel's control. And for years, skeptics have dismissed such claims as cover for the cartel's greedy unwillingness to pump more oil.

Recently, however, even the skeptics are acknowledging the price-pushing power of non-OPEC forces in the oil market – forces that could be doing importers as much damage as anything the cartel ever tried.

The most obvious is the sagging dollar. Because oil is priced in dollars, and because the dollar's value has fallen nearly a third against major developed-country currencies since 2002, Americans are spending more – perhaps as much as $20 more – for a barrel of oil.

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And that pales against what speculators might be adding to the price.

Although all commodities can be manipulated by speculation, oil is especially vulnerable. First, oil is prone to supply disruptions, whether from hurricanes or border wars. Second, the global oil system is highly opaque. It has so many pieces – producers, refiners, shippers and distributors – that no one knows precisely how much oil is in any given place at any given time. This means that estimates of how much excess inventory is in the system – and thus, how big a buffer we have against a disruption – can change rapidly.

So when the United States Department of Energy, for example, announces a "surprising" decline in US oil inventories – and by implication a smaller buffer – the oil market responds by driving up prices.

Oil is, in other words, an inherently volatile commodity and thus highly attractive to traders, who profit by betting on the daily and even hourly fluctuations in price. And while there's nothing criminal about betting on price, it is a problem when the bets themselves influence the price. If enough traders gamble that oil prices will rise over, say, the next 30 days, then the price of 30-day oil futures contracts will rise, which eventually will pull up the current, or spot, price of oil – the classic self-fulfilling prophecy.

And because traders are always looking for anything that might warrant a price increase (and thus, the placing of a bet), the smallest events – unrest in Nigeria, for example, or even upbeat economic news (which implies greater oil demand), become potential catalysts for a price rise.

Just how large this "speculative premium" is has become a matter of intense debate. Historically, says Fadel Gheit, a veteran oil analyst at Oppenheimer & Co. in New York, oil prices have run about three times what it costs to physically extract a barrel from the ground. Given that these extraction costs run between $15 to $19 a barrel worldwide, the "correct" price should be somewhere between $45 to $57. Indeed, as recently as 2005, OPEC itself claimed that $45 was a reasonable price.

If that's true, then we're paying a speculative premium of up to $45 for each barrel, or about $1 for each gallon of gasoline.

If nearly half the price of oil isn't justified by fundamentals such as supply and demand, then sooner or later the price must fall.

In theory, that ought to mean that a trader willing to bet against the market by buying an oil futures contract for a lower price, should make a fortune. But in recent years, says Gheit, "anyone who has bet against the market has had their head handed to them" because the price keeps rising.

Why? The answer is complex. First, even with a speculative premium, the oil market is still out of balance. Demand for oil, especially in booming China and India, is rising faster than supply. And tight markets are prone to perturbations – be they caused by political events, hurricanes, or, more recently, speculators' bets.

What, if anything, can be done about the speculator premium? Various commentators have called on Washington to regulate commodity speculation or release some of the nation's Strategic Petroleum Reserve and thus flood oil markets.But motorists shouldn't hold their breath waiting for policy action. When it comes to oil, our lawmakers have an abiding faith that the markets will sort themselves out; that when gas prices get high enough, demand will fall, and so will price.

Meanwhile, Washington's free-marketeers should bear in mind that the cost of the speculator premium goes beyond angry motorists. Every dollar increase in oil prices represents a huge bonus for oil exporters, not all of whom can be trusted to use it wisely. Iran, for example, is now raking in roughly $5.5 billion extra a month because of the speculator's premium – cash that could be used to fund any number of nasty ventures, and that could offset whatever economic sanctions Washington manages to deploy against Tehran.

In the ultimate oil irony, even the merest mention by President Bush of sanctions against Iran is enough to push up oil prices – and thus to send even more dollars to Tehran.

Paul Roberts is the author of "The End of Oil: On the Edge of a Perilous New World." ©2007 The Los Angeles Times.

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