$55 oil won't last

Larry Kudlow
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Posted: Mar 11, 2005 12:00 AM
When I put a $55 barrel of oil on the table and look at it from all angles, there?s no way the current price can be justified. As a free-market disciple, I am compelled to accept the market?s verdict: $55 a barrel. But that doesn?t mean it?s going to last.

Today?s oil episode is demand-driven, quite unlike the supply shocks of 25 years ago. Back then, OPEC withheld oil because they disagreed with the U.S. policy-tilt towards Israel. Additionally, under Presidents Ford and Carter, U.S. energy policy generated strict price controls and supply allocations, a most bizarre policy combination that kept oil from those population centers most in need of it.

Oil is certainly flowing today, but at much higher prices. In fact, in real inflation-adjusted terms, today?s oil price is the highest since 1983. To a certain extent, we owe this to a favorable development: the global spread of market capitalism in emerging economies such as China, India, and Eastern Europe. At the margin, the increasing oil demands of these countries have undoubtedly boosted the barrel price.

It is instructive to note how much higher oil prices have jumped in comparison to other commodities. From the 2001 low, oil has increased 214 percent. Over the same period, an index of metals -- equally in demand from the emerging economies -- has risen 122 percent. Seemingly along for the ride, gold prices have increased 73 percent. Meanwhile, the S&P 500 stock index has rallied 55 percent from its late 2002 low point while the broader Wilshire 5000 has gained 62 percent.

The fact that oil has increased so much more than these commodity and financial-asset prices is important. It suggests that the oil sector is way out of line. Increased China demand cannot alone explain it -- over-speculation is also a culprit.

It is rumored that hedge funds have used low interest rates to leverage and borrow for the purchase of oil market contracts. Big oil companies may also be speculating on higher future oil prices, with or without leveraged borrowing. It may also be that tanker companies have slowed down their deliveries as they wait for still higher prices.

Fortunately, the U.S. economy is much less susceptible nowadays to the tax-hike impact of higher oil prices. Numerous studies have shown that greater efficiencies in oil and energy usage have lowered our vulnerability to energy shocks by roughly 50 percent in relation to 25 years ago. Rather than stagflating, today?s economy is quite healthy.

So, what to do?

Ultimately, the answer to high oil prices is a lot more production. That?s exactly what the Bush administration intends to do. New Energy Secretary Sam Bodman has been put in place to implement Bush policies for greater nuclear energy use, increased use of clean coal, the development of a free-trade national electricity grid, and the foreign coordination of liquid natural gas. Also in the policy mix is new oil and gas drilling in the Arctic National Wildlife Refuge (ANWR).

Is Bodman the right man for this job? Absolutely. Bodman, a chemical engineering scientist who has taught at MIT, was the chief operating officer of the super-sized Fidelity mutual fund company and is a former venture capitalist. This is a guy who will quietly manage the U.S. effort to break out of the current OPEC-reliant paradigm and shift to the development of multiple new energy sources.

We?re already seeing signs of progress. The Excelon utility company has just received an early site permit for nuclear power, and Duke Power has nearly completed its combined operating license permit, which includes a pre-approved reactor design.

Meanwhile, there?s still a lot of oil out there. ?Hard Green? author Peter Huber has suggested that there are 3 trillion barrels of oil buried in Venezuela and Alberta, Canada. Washington policy analyst James Lucier also notes that individual states are taking matters into their own hands by exercising states? rights to drill on the outer continental shelf. In Virginia, Democratic governor Mark Warner is expected to sign an OCS drilling bill from his legislature to do exactly that.

The key point is to let markets work. Free-market pricing will best allocate the shifts in both demand and supply. Spiking energy prices will reduce consumption. They will also attract capital investment leading to much greater production. That is, if government policies allow markets to work.

In the meantime, small investors thinking about jumping on the gravy train of higher oil prices should beware. Bubbles happen. And a major oil bubble could be on the verge of bursting.