March
12, 2005
$55 Oil Won’t Last
By
Lawrence
Kudlow
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, US 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 US 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 US 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.
Lawrence
Kudlow is a former Reagan economic advisor, a syndicated
columnist, and the co-host of CNBC's Kudlow
& Company.
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