- The Washington Times - Sunday, March 13, 2005

When I put a $55 barrel of oil on the table and look at it from all angles, there’s no way to justify the current price. As a free-market disciple, I am compelled to accept the market verdict: $55 a barrel. But that doesn’t mean it will last.

Today’s oil episode is demand-driven, quite unlike the supply shocks of 25 years ago. Back then, OPEC withheld oil because members disagreed with the U.S. policy-tilt toward Israel. Additionally, under Presidents Ford and Carter, U.S. energy policy generated strict price controls and supply allocations, a most bizarre policy combination that kept oil from those population centers that most needed 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.

That oil has increased so much more than these commodity and financial-asset prices is important. It suggests the oil sector is way out of line. Increased China demand cannot alone explain it — overspeculation is also a culprit.

Hedge funds are rumored to have used low interest rates to leverage and borrow to buy oil market contracts. Big oil companies may also be speculating on higher future oil prices, with or without leveraged borrowing. Perhaps tanker companies also have slowed deliveries as they wait for still higher prices.

Fortunately, the U.S. economy is now much less susceptible to the tax-increase effect of higher oil prices. Many studies have shown greater oil and energy use efficiencies cut our vulnerability to energy shocks by about half compared 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 carry out Bush policies for greater nuclear energy use, increased use of clean coal, development of a free-trade national electricity grid and 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 Mr. Bodman the right man for this job? Absolutely. Mr. Bodman, a chemical engineering scientist who has taught at the Massachusetts Institute of Technology was chief operating officer of the super-sized Fidelity mutual fund company and is a former venture capitalist. This guy will quietly manage the U.S. effort to break out of the current OPEC-reliant paradigm and shift to developing multiple new energy sources.

We’re already seeing signs of progress. The Excelon utility company just received an early site permit for nuclear power, and Duke Power has nearly completed its combined operating license permit, including a preapproved reactor design.

Meanwhile, there’s still a great deal of oil out there. “Hard Green” author Peter Huber has suggested 3 trillion barrels of oil are buried in Venezuela and Alberta, Canada. Washington policy analyst James Lucier also notes individual states are exercising states’ rights to drill on the Outer Continental Shelf. In Virginia, Democratic Gov. Mark Warner is expected to sign an OCS drilling bill passed by his legislature to do exactly that.

The key is to let markets work. Free-market pricing will best allocate 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.

Meanwhile, 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 host of CNBC’s “Kudlow & Company” and is a nationally syndicated columnist.

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