I have been getting emails from readers essentially asking me to do a post on oil - why is it so expensive, and what, if anything should be the GOP’s party platform on energy. While energy economics is not my specialty - I do understand commodities markets, and I believe I probably understand better than most what’s causing the run in the price of oil. Since I’m all about serving my readers at Right Commentary - this post is for you.

First, the current “oil crisis” is a crisis of our own doing. In 2004, several economists and energy experts noted that at the current rate of industrialization, supplies of energy would necessarily tighten over the next decade. At the time, few seemed to understand this fact, since oil was about $38/barrel on average, and gasoline costs were approximately $2/gallon. From 2004 to now, the price of both crude oil and gasoline have skyrocketed. Oil is now three and a half times what it was three years ago, and the price of gas has more than doubled. Thus, the “crisis” in oil didn’t just “sneak up on us” in the last year. Prices have been steadily rising steadily since 2000, after about a decade of relative price stability - with oil prices ranging from 16-23 dollars per barrel.

Also, demand for oil hasn’t exactly snuck up on us either. In 2004, predictions were made that the world wide energy intensity would increase. While energy intensity in the US is falling, in large part because of economies of scale and efficiencies made in the use of energy, overall energy demand is skyrocketing. Oil demand alone has increased by more than three million barrels a day. As countries like China and India become more industrializes, and the demand for products that contain oil worldwide grows with the world’s population, demand for oil will continue to increase. China and India are especially critical to this discussion because their rapid growth rates mean they will account for the single largest chunk of the “increase” in the use of oil over the next 20 years.

Second, some things have happened since 2004 to the US economy that have made oil expensive. The first element to the “economic piece” of the puzzle is the value of the US dollar. From 2005 to now, the dollar has steadily dropped against major currencies. This is in part because of an investor-led devaluation due to the massive borrowing of the United States since 2003 to finance the wars in Afghanistan and Iraq (along with an increasing debt burden brought about by entitlement programs). The second piece is that as the US dollar falls, investors will look to other types of investments to maintain the rates of return needed from their investment portfolio. One good way to do that is to invest in OIL. These people are not speculators per se (I’ll get to the speculation in amoment), but they are buyng and selling oil in both the spot and futures markets as hedges against inflation and a weakening greenback. That fact makes the competition for oil in the market more intense - and as the price goes up - so do the returns - and it draws in more dollar denominated assets. Further, this cycle doesn’t seem to be done - last week, a drop in US employment figures lead to a $11 increase in the price of oil in one day. (BTW - for those of you who hate hedge funds and speculators in oil, most of them got their asses kicked that day, as most of them were speculating AGAINST a rise, and got whammied when the market reversed on them by the dollar traders.) As the US economy weakens, it necessarily drives a price increase in oil.

Third, despite what idiots in the Democratic party may say - the reality is, the market is significantly under supplied a this moment. Demand is probably outstripping supply by about two MILLION barrels of oil a day. That is why the Saudi’s announcement  to increase oil supplies had no appreciable affect on the price of crude oil. It was instantly absorbed. In order for supply to matter - the amount of supply must be more than demand, and allow for the development of oil inventories in major importing nations. Once inventories rise high enough, worldwide demand slows down, and prices begin to drop. As it is right now, the supply is incredibly tight worldwide - and events like shutting down refineries in Nigera make a tight market even worse.

This brings me to the fourth concern, namely, political instability. Most of the world’s “deliverable” oil (I say that because it highlights the fact that there are billions of barrels under the US we refuse to bring to market) is in the hands of totalitarian regimes that suffer significant political instability. Saudi Arabia is perhaps the key worldwide to oil - and that regime is always under threat from challengers, al Qiada, and other forms of political instability. Hugo Chavez (Veneuzela)- where the United States gets most of it’s oil from - has repeatedly suffered attempts on his life and coup d’etats. Investors worldwide, and purchasers of oil, watch the instability patterns very closely, and attempt to guage the impact it will have on supply. As political instability increases - such as threats to attack Iran (an OPEC state) - so will the price of oil.

This brings me to the last concern - price speculators. Speculation has been demonized and scapegoated recently because it’s a simple political ploy to blame “evil market speculators,” since in large part no one has a clue who the heck they’re talking about when they say that.

First of all - market speculation is not evil. Almost all commodities markets have what are called “futures” markets. The futures markets help businesses that use commodities smooth out their costs over time. In situations where a  time lag exists where commodity is produced and then consumed, businesses will try to ensure their “cost structure” ahead of time by trying to secure the rights to purchase the product at a specified date and price. This is essentially what futures markets do - they allow consumers of a product to fix in a date and time certain, for a certain price, the commodity they will buy. For example, airline companies smooth out the “ups and downs” in jet fuel prices by buying futures for the delivery of jet fuel. Coca-Cola buys futures to ensure they have enough sugar and corn to make soda throughout the year - and it makes it easier for them to know what the price will be - since it’s fixed in advance.

Secondly - oil speculation is largely being driven by the weakened dollar and US economy. As hedge funds look for ways to improve their returns - OIL is a really great investment. Oil prices continue to provide good returns, and because they are dollar denominated assets with high degree of liquidity - they make for an easy target for investors of large sums. While it is true that some speculation is truly that - guys going “Gee Bob, what are you willing to pay for oil in February of 2009?” Most of the speculation is really a hard-nosed calculus of supply and demand, evaluations of political instability in oil producing nations, the strengths and weaknesses of refining capability and relative energy transformation coefficients, and other factors that make investors wonder which way the price of oil is going to go. While energy traders in the market have grown as the price of oil has increased - I don’t think it’s really true that speculation is driving the market. The other four factors I’ve mentioned are much more prominent than speculation, thus, I’m dubious of efforts by people such as Barrack Obama to regulate “speculators.” Speculation is a political scapegoat.

Okay - whew! So as you can see, a great deal goes into what makes oil prices rise and fall. All of that said - what makes for the right politics for the GOP? The answer is quite simple - we have to increase our supply of crude oil by making exploration, energy diversification, and self-sufficiency a prime goal of a national energy policy. Turning off lights, and driving less will not materially help us. Deciding the spotted owl is more important than avoiding $30/gallon gasoline is ridiculous. We need a serious energy policy.

Any energy policy needs to include, in my view, the following key items:

• We need to exploit and explore all of the oil within the waters of the United States and on US territory or soil. Now, I want exploration done in a ecologically sound way - but saying we can’t drill no matter what is suicide. There needs to be a balance between our energy needs and the ecology - one cannot take absolute preference over the other.
• We do need to improve energy efficiency - increasing automobile efficiency among other variables. We should be providing incentives to automotive manufacturers to make more efficient cars. We should also be providing incentives to develop alternative fuels.
• We need to STOP all incentives for gasohol. Ethanol is a disaster. Let the people of Iowa find some other subsidy. By tying energy stocks to food stocks - we’ve screwed up two markets. If ethanol is truly going to be viable in the market - the alcohol needs to be derived from something other than corn, and those technologies are available.
• We need to stop all this stupidity about nuclear power and build power plants. We are an energy intensive society that will need more energy. While nuclear power is not danger-free, compared to other types of power generation activity - it is safer, produces less waste (in terms of volume), and is ecologically manageable. For all you lefities out there who love the Europeans - they’re building nuclear power plants like mushrooms sprouting all over a field.
• We also need to improve our ability to use coal cleanly. We have vast amounts of coal, which cost less per kilowatt than other types energy generation - especially oil.
• We need to develop a comprehensive incentive strategy for firms and scientists to develop alternative energy. We put men on the moon. We can find ways to improve our energy supply - it’s just a matter of time and money.

Those elements would make for a logical energy policy consistent with the Republican platform of free-market enterprise. The Government’s inaction is largely responsible for the mess we are in - it’s time to get our act together and start making America less dependent on the likes of Chavez and King Abdullah.

One final word - when Liberals talk about global warming, when the talk about not drilling in ANWR, when they talk about placing “global change” against global development - that accounts for at least 20-30 cents per gallon at the pump… and rising.