Four Dollars a Gallon?!

Why oil prices are rising, and why they're unlikely to drop anytime soon.

Oil prices have been soaring for the last few years, and they're making themselves felt in nearly every facet of American life. Consumers feel it most at the gas pump, but higher gas prices translate to higher shipping costs, which makes nearly everything else go up. Understandably, people are angry and want answers, solutions, or at least someone to blame. Why are gas prices spiking so suddenly?

The answer actually has a lot to do with everyone's favorite fundamental law of economics: supply and demand. As Earth's population continues to rise, and as more and more countries become industrialized, demand for crude oil will go up. There's really no way around that. If supply doesn't increase to meet demand, then prices go up. American demand for oil hasn't risen particularly - in fact, considering the recent trend away from SUVs and other gas-guzzlers in favor of hybrid cars, oil demand is probably slightly lower than in recent years - but demand from rapidly growing countries, especially China and India, has. Essentially, the United States are seeing new competition in the global oil market from these new Asian powers, and they have to pay more for it.

Much has been made of OPEC's refusal to increase global oil supply, but unfortunately, it's not such a simple matter as turning on a faucet. OPEC's production is limited by the amount of drilling stations they have. They can't produce more oil than they can extract from the ground, and drilling new sites is extremely costly and time-consuming. Even if more drilling is profitable at over $120/barrel (and it probably is, even in difficult to refine areas like Canada), it will take time before the added supply can be felt in the global market. So we can effectively rule out increases in supply in the near future, all but guaranteeing increases in oil prices in the face of growing demand.

However, the global oil supply isn't actually static. In reality, it's been decreasing steadily over the last few years. Iraq, one of the world's largest oil producers, has seen its exports plummet since 2003 as it deals with massive civil unrest. In some cases, Iraqi oil exports have fallen over two million barrels of oil per day. That's a pretty significant drop. Nigerian unrest led to similar drops in production. Simply put, rising demand and slumping supply lead to vastly increased prices.

So why have prices gone so high lately? Average U.S. gas prices have risen about 39 cents per gallon over the last month, a rate higher than the conditions above would have dictated. The missing factor? Speculation. Investors (particularly those managing hedge funds) are buying up oil futures because they think the price of oil will continue to increase. As more and more investors buy up oil, the price goes up (think rising demand and static supply again). This creates a price bubble, similar to the recent housing bubble and the dot-com bubble of the late 1990s. That provides hope for consumers, who yearn for the day that the oil bubble bursts and prices drop again. However, the housing and dot-com bubbles both burst because of an overabundance of supply. Too many nonprofitable houses and mortgages led to a sudden drop in price. The same thing happened with dot-com businesses. However, there's no reason to think that the same will happen with oil. Fossil fuels are a non-renewable resource. Sooner or later, supply will start to shrink as reserves run out. Some believe we've already hit that point; others think it will arrive within the next 20 years. Barring some unforeseen increase of supply or decrease in demand, high prices are here to stay, which is bad news for common people stuck paying four dollars a gallon at the pump.