What has driven up oil prices

Speculation and a falling dollar may now be as important as supply and demand, analysts say.

By , Staff writer of The Christian Science Monitor

The recipe for record US gasoline prices goes like this: Take a tight oil supply and growing world demand. Add a falling dollar and lots of investment money flowing into oil and other commodities.

Finish with market turbulence caused by the annual switch from winter to summer gasoline blends. The result: an average US retail price for regular of more than $3.60 a gallon.

Will gasoline stay that high? At least through the summer, say experts. At the margin, pump prices may now depend on currency fluctuations and financial speculators as much as on traditional economics.

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"The old fundamentals – the balance between demand and supply – still matter, but it is these new factors that are the driving force behind the record high," concludes a recent analysis by Cambridge Energy Research Associates.

On international markets, the price of a benchmark barrel of oil has retreated a bit in recent days. But the recent state of the market can be seen in the fact that on May 1 Exxon Mobil Corp. reported first quarter net income of $10.89 billion – its highest ever.

Average US retail gas prices have risen for five weeks in a row, according to the Energy Information Administration's latest available figures. At $3.60 per gallon, the average price of a gallon of regular has now spiked 21.4 cents since April 14.

Looking back a bit further, gas prices have climbed over $1.40 a gallon in 18 months. Sure, China and India are getting richer and their citizens are using more petroleum. But has everyone in Guangzhou purchased a Cadillac Escalade since, say, March?

"The market has gone [so high] for a variety of reasons, some of which are fundamental, and some of which are speculative," says Amy Myers Jaffe, a fellow in energy studies at the James A. Baker III Institute for Public Policy at Rice University.

Perhaps the most fundamental of the fundamentals is supply – specifically, a flattening in the growth of available oil reserves.

Throughout the 1980s and 1990s, increases in demand for petroleum products were quickly counterbalanced by the appearance of new sources of supply, say experts.

That pace since has slowed. New fields are still being discovered, in Brazil and other places around the globe, but it takes a long time to make them operational. Meanwhile, the end of the era of cheap and easy oil extraction may be coming.

"Since 2000, we have hit a more mature period in terms of supply. At the same time, we've had the demand shock come into play," says David Pumphrey, deputy director of the energy and national security program at the Center for Strategic and International Studies.

Global economic expansion has resulted in a world demand for oil that has been rising steadily – and has proved remarkably resilient in the face of high prices.

According to Cambridge Energy Research Associates, world oil demand will increase a further 1.3 million barrels per day in 2008, with Asia and the Middle East accounting for 800,000 barrels per day of that growth.

To put that figure in context, the US consumes about 20.6 million barrels per day, or roughly 25 percent of global demand. China is the second-largest consumer, at 7.2 million barrels per day. Japan, with 5.2 million barrels per day, is third.

High gas prices have dampened demand somewhat, but not as much as might be expected, according to Jeroen van der Veer, chief executive officer of Royal Dutch Shell.

The demand reaction to continued high prices might be a delayed one, said Mr. van der Veer at a recent symposium at the Council on Foreign Relations.

"We think it may happen that people won't drive less, but that next time they buy a car they will buy a more fuel-efficient car," he said.

Then there are the reasons for high prices that fall under the "speculative" category referred to by Ms. Myers Jaffe.

Prime among these is the fall in the value of the dollar relative to other currencies. Oil is denominated in dollars, so that if the dollar becomes cheaper relative to, say, the euro, producers need higher prices if their global purchasing power is to remain the same.

This phenomenon may have accounted for as much as one-third of the rise in price of a barrel of oil since December 2000, according to Baker Institute calculations.

With world stock markets volatile, and the US credit crisis leading to unpredictable effects around the world, investment money is also flowing into oil and other commodities, which are seen as more stable, safe bets. This puts further upward pressure on a barrel's price.

The total effect of these financial pressures is a matter of some dispute among experts. Many OPEC nations, for instance, blame financial speculation for much of the recent increase. Others hold that the market believes supplies will remain tight for some time to come – meaning fundamentals remain the most important oil price pressure.

Will prices stay high? That depends in part on the prospect of geopolitical events, such as unrest in Nigeria, that can cause spikes.

Mr. Pumphrey says, "we are looking at prices above $100 [a barrel of oil] for the rest of the year."

Myers Jaffe says the price reflects a "bubble" and that the market is due for a correction.

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