Why Do Oil Prices Swing So Wildly?

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". . .supply and consumption—are no longer in the driver's seat."

Over the past two years, the price of a gallon of gas has ranged from an average of $1.60 to $4.11. That's nuts. While the Arab oil embargo, Iranian revolution and Gulf War provoked big price jumps at the pump, not one of those events caused a two-year round trip as dramatic as the one we've just seen.

Four major factors determine oil prices—supply, consumption, financial markets and government policies. Supply and consumption are no longer in the driver's seat. This year there has been abundant supply and slowing demand, but prices have doubled. Economics 101 says that shouldn't happen. But it has.

"In today's world, oil-price dynamics are different than even 10 years ago," says Kenneth Medlock, an energy economist at the Baker Institute.

Prices are not just curious; they are wild. From 1999 to 2004, the biggest difference between the high and low price in any given year was $16; from 2005 on, the average variance was $52—but in 2008 it was $115. Investment in commodity indexes, which are heavily weighted in oil, has risen sharply, from about $15 billion in 2003 to $200 billion last year.

There is a relationship between increased investment and increased volatility, so speculators are making a big difference in the oil market. The CFTC is considering new rules for the oil markets.

One reason prices have been rising so strongly this year is that futures traders are doing what they do—anticipating. Just as stock prices anticipate future returns, so do commodity prices. Traders are betting the global economy will recover later this year and supplies will, therefore, tighten.

Over the long term, there is something akin to consensus that the days of cheap oil characterizing most of the 20th century are gone. While new CFTC regulations might cool some of the hottest money—if the oil markets elsewhere do not follow suit, all the other factors argue for higher prices. When the economic recovery comes, consumption will also rise in the U.S. and Europe. And the drop-off in investment means that once the current overhang is sucked up, demand will rise faster than supply.

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