ANALYSIS / When a Single Comment Raises Oil Costs, Market Is in Trouble

The $8 price jump after Mofaz's Iran threat, general doubling in barrel costs shows world economy changing.

Israeli observers sneered. If Israel's transport minister, in his ravening for headlines, in his political intriguing, in his petty little party hackery, can raise the price of oil in world markets by $8 to an all-time high (at least for a few hours), then the oil market evidently isn't a place where things are thought through in depth.

Shaul Mofaz did indeed make a fool of himself, and of traders in the world oil market, too. But don't let that comical incident fool you. The surge of oil from around $70 to almost $140 per barrel in the last year reflects real change in the world economy, not passing whims of traders in a speculative market.

Almost 30 years have passed since oil seized the broad public's attention. Barring pinpoint spikes caused by specific events, such as the first Gulf War, the general public tends to overlook oil while fixating on the likes of the stock market, real estate, technology, commerce and even the Internet. But oil has made its comeback, bursting through new barriers by the week to heights that had been thought impossible.A year ago, $100 per barrel had been an apocalyptic vision; now $200 per barrel is the word in capital market circles.

As always, when things are moving at warp speed, there are those who lose their heads, declare a new era, scrabble about for scapegoats and mainly, declare that such a thing has never been seen before.

Most folk around the world didn't really react in any meaningful way to the first $100 increase. But as the months pass, the increase will start seriously impacting consumer pockets, corporate profits and the national balance of payments the world over. Except, of course, for the oil-exporting countries.

That is when we will start hearing cries to:

* Lower tax on gasoline, oil and distillates

* Quash speculative activity in the oil market

* For the government to intervene in the marketplace, pass laws, impose rules, grant subsidies, attack Iran, threaten Russia, talk with China, stop talking with China, start a war, or institute a truce

Here's a proposal you aren't likely to hear, especially if oil reaches $200 a barrel. Namely, to leave the market alone. Let it do its thing. Let supply and demand do their trick.

True, that's boring. No politician ever made his career screaming from a soapbox to do nothing. No pundit ever built up a following by not calling for action.

But before the explosion in oil sets fire to the economic debate and the apocalyptic forecasts start raining down, inspiring investors to hedge (or gamble on) the black goo, let's look at some boring but pertinent facts.

But don't think that the spike in oil is a speculative figment. Don't forget that speculators and investors aren't buying barrels to stick them in the cellar. Their most speculative action in the oil market is in futures. Buyers and sellers of futures don't take possession of actual barrels of oil, and for each seller there's a buyer. Unlike actual barrels of oil, there is no limit to the amounts of paper changing hand. Theoretically, speculation about oil could grow to infinity. Obviously, the more oil-linked options and derivatives are being traded, the greater the potential fluctuation in prices. But at the end of the day, market prices of actual oil will depend on buyers and sellers of the actual barrels of oil themselves.

The oil industry is slow and cumbersome. Developing new fields is a slow and expensive process. From the moment a decision is made until oil actually starts flowing through pipelines, between five to 15 years can pass, depending on the type of field.

The wild increase in oil prices will dramatically increase both investment and supply. But it will take time. Look at the huge field just discovered off Brazil: it's believed to house 10 to 20 billion barrels of oil worth some $6 trillion, but production is likely to only start in 20 years, after an investment of $240 billion.

Demand will also adjust to the price levels. Demand for oil has continued to climb, but the pace is already slowing in the richer countries and that will happen in the rest of the world, too. Many countries subsidize oil, for various reasons, but their ability to do so will ebb. As the subsidies are reduced, demand will drop, too.

Naturally, the increase in oil prices will dramatically impact the global balance of power. The political and economic clout of oil producers such as Russia, Saudi Arabia and the Emirates will increase, but one must distinguish between the short run, the medium term and the long one.

Nobelist Gary Becker runs a blog in which he discusses the issues of the day, together with his colleague Richard Posner ( A month ago Becker explained why oil could never reach $200 per barrel, barring a terror attack that would significantly hamper supply. Becker, an economist who studied the behavior of oil prices for years, discovered that in the near run of five years, the demand and supply curves of oil are actually very rigid. Doubling the price per barrel reduces demand by just 2% to 9% and increases supply by only 4%. But, unsurprisingly, in the longer run - the results are completely different. A doubled price per barrel reduced demand by 60% and raised supply by 35%.

Posner agrees, saying that the chance of oil reaching $200 is remote, which he thinks is a pity. He would love to see oil at $200 per barrel, and fast, because of government taxation, which would spur the development of alternative energies. But, he laments, the probability of politics producing a tax like that is vanishingly small.

Political intervention could spur the development of alternative energies, but if oil prices remain high, the answer will arise from the marketplace itself. Despite the perception of oil as possessing some sort of magical quality, at the end of the day it obeys the rules of supply and demand, just like shoes or potatoes. Just give it time.