THE $100 DOLLAR OIL PANIC / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( VERY HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

FEBRUARY 24, 2011.

The $100 Oil Panic

A Libya premium on top of the Bernanke premium.
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Our question is: What took so long? We're referring to the latest oil market panic, as prices for U.S. crude hit $100 a barrel yesterday (European crude hit $111) and gasoline nears $4 a gallon in parts of California. This oil trouble has been building for some time, and there's much more at work here than turmoil in the Middle East.


The latest price spike follows the outbreak of what looks like civil war in Libya, which produces about 2% of the world's oil. Saudi Arabia's energy minister says his country has the capacity to make up for any shortfall from Libya, and so he does.


But oil traders are already beginning to discount for the risks if the demand for more political freedom also spreads to the Kingdom, which produces 10% of the world's oil. Karen Elliott House's recent piece on these pages explained in persuasive detail why that is not a far-fetched scenario. We hope the Obama Administration is making contingency military plans to protect those oil fields if it comes to that.


As for Libya, any rational successor government to Moammar Gadhafi is going to want to sell oil to the world. The faster the Gadhafi clan is overthrown and the violence stops, the better for the Libyan people and oil supplies. At least President Obama finally sent an envoy to Europe yesterday to explore joint action to stop what he called "outrageous" violence against protesters. But he still couldn't bring himself to call for regime change.


It's important to keep in mind, however, that oil was already trading in the $85 to $90 a barrel range before the recent irruption in the Arab world. The run-up to that price territory began in earnest last year after the Federal Reserve embarked on its QE2 strategy of further monetary easing.


The Fed absolves itself of any responsibility for rising oil prices, attributing them to rising demand from a recovering global economy. Demand has been rising, but not enough to explain what has been a nearly across-the-board spike in prices for dollar-traded commodities. (Natural gas is the big exception, thanks to a boom in domestic exploration.) A spike in one or two commodities can be explained by a change in relative demand. A uniform price spike suggests at least in part a monetary explanation. The Fed will use the Libya turmoil as another alibi, but there's no doubt in our mind that oil prices include a substantial Ben Bernanke premium.


The $100 oil plateau is also bringing out the usual suspects demanding that we end our "addiction to oil"—as if that were even remotely possible short of some great technological breakthrough. The last such political mania in the waning Bush years gave Congress an excuse to hand out more corporate energy subsidies, amid promises that cellulosic ethanol and wind would go to commercial scale in short order. We're still waiting, as the ethanol fiasco at Range Fuels attests. Meanwhile, oil imports keep rising despite additional mandates for corn ethanol.


While we await energy miracles, rising oil prices will act like a tax on American consumers. The U.S. consumes about 7.5 billion barrels a year, so every $10 a barrel increase costs the U.S. economy about $75 billion. Since over half of that oil is imported, the benefit flows to foreign producers.


This would seem to cry out for more domestic oil production, including an end to the Obama Administration's de facto drilling moratorium. But this conflicts with the President's larger energy agenda, which is to deliberately increase prices on fossil fuels so alternative energy sources become more competitive. This is the strategy behind cap and tax, which the Administration is now trying to impose via regulation, as well as the limits on domestic oil and even natural gas drilling.


The U.S. economy is in better shape now than it was in 2008 to withstand $4 a gallon gasoline. The problem is that higher gas and other commodity prices reduce the real incomes of Americans. The White House and Fed have placed a very large bet that their reflation efforts will result in higher stock and housing prices, creating a "wealth effect" that will increase confidence and spur growth. That has happened in stock prices, at least until this week's correction.


But any wealth effect is being offset, especially for middle-income earners without big stock portfolios, by higher prices for food and gas, among other things. As higher prices flow through to the pump and grocery store, middle class Americans are poorer than they otherwise would be. They feel poorer too—which affects their confidence in the larger economy, and in Mr. Obama's economic policies.


If the President wants to reduce the chances of an even bigger oil price spike, we'd suggest that his Treasury Secretary advise Mr. Bernanke to pull the plug on QE2 and return to a normal monetary policy. Then get working on a policy to keep oil flowing in the Mideast, and to drill for more of it at home.


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