Gas prices are the first important issue in the 2008 elections. But both parties have been pathetic in their solutions and, one suspects, in their understanding of what is going on.

Democrats call for windfall profits taxes. Bad idea. How can you get oil companies to explore and drill if you tax away their profits? Republicans focus on a gas tax “holiday,” an 18-cent palliative to gas prices that now top $4.50.

Fadel Gheit, managing director of oil and gas research for Oppenheimer and Co., and Jim Norman, author of the book The Oil Card, coming out next month, say that speculation is responsible for a huge part of the run-up in prices.

The growing demand for oil by India and China and the instability of oil supplies certainly account for much of the increase. But the recent spike, they say, is equally due to the weakness of the dollar and massive speculation.

They argue that oil prices are, indeed, determined by supply and demand — not only the supply and demand for oil, but also the supply and demand for oil futures. (Oil futures are a commitment to buy 1,000 barrels of oil at a certain date at a certain price.)

Formerly, most of the investments in oil futures came from energy companies. The federal Commodities Futures Trading Commission (CFTC) sharply limited investments by those outside the business, to prevent precisely the kind of speculation now gripping the market.

But when the stock market slowed down in 2000–2002, outside investors decided to speculate in oil futures.

The new players were institutional investors like corporate and government pension funds, sovereign wealth funds, university endowments and other investors, guided by brokerage firms like Morgan Stanley and Goldman Sachs.

To avoid the CFTC caps, these investors moved their operations to London, setting up the International Commodities Exchange. Now they can buy all the oil futures they want.

Michael W. Masters, of Masters Capital Management, told Congress that the volume of investment in commodities futures soared from $13 billion at the end of 2003 to $260 billion by March of 2008.

After a while, the CFTC rescinded its limits on how much speculators could buy as long as they went through special “swap” desks at the major brokerage houses. Continued...