Oil Price Defies Easy Calculation

CalPERS says its commodities stake falls into the category of "inflation-linked assets," and rising expectations about inflation are sustaining the flow of money into commodities, which in turn is fueling more inflation.

"I think more cash will come in and keep coming in until people are convinced that the Federal Reserve is going to do something about inflation," said Philip K. Verleger, an Aspen, Colo.-based oil analyst.

Verleger estimates that the flow of money into oil commodity investments rose from $450 million a week to $3.4 billion a week from the time the Fed cut interest rates in January until mid-March. Unlike traditional oil traders, the hedge, investment and pension funds are buying oil to diversify their portfolios, he said. That means that high oil prices have not stopped them from buying more.

That could alter the nature of oil markets, which have swung up and down ever since oil was found in Pennsylvania in 1859. Traders in commodity markets are now expecting continued high prices. On the New York Mercantile Exchange, the delivery price of crude oil for any month through December 2016 is no lower than $99 a barrel.

Global factors matter, too. The Organization of the Petroleum Exporting Countries cut production in January 2007 to keep prices from falling below $60. Rapidly increasing oil consumption in developing countries such as China is also propping up prices. And it is becoming harder to find new oil.

Shell's Van der Veer said he expects a crunch in energy markets in 10 or 15 years. "The easy oil and easy gas will not be sufficient," he said.

How that translates into today's oil prices is not clear.

Some economists say the price of oil today should be slightly higher than the cost of finding and producing a new barrel of oil. If that were the case, the price might be about $60 a barrel, the cost of getting oil from Canada's abundant tar sands.

Saudi Oil Minister Ali al-Naimi said recently that the Canadian cost was the new price floor -- even though world oil market prices only surpassed that level a year ago. Yesterday, Total chief executive Christophe de Margerie told an energy conference in Paris that "there is a new floor linked to costs" of developing new fields, and he said prices would stay above $70 a barrel.

Other analysts say the cost of developing new oil fields is much lower, as little as $10 a barrel, in much of the Middle East but that war in Iraq and restrained expansion in Saudi Arabia prevent cheaper oil from coming onto the market. Investment obstacles from Russia to Mexico also keep current production lower than it might be.

Still other economists say that the price of oil should be whatever the market will bear, and consumers have shown they can bear a lot. Although the EIA expects U.S. motorists to use slightly less gasoline than they did last year, that seems like a modest response, with pump prices at all-time highs.

Verleger argues that "fundamentals have never had much to do with prices. The floor for oil is around $10 per barrel. The ceiling has never been determined. What matters is market structure. Crude markets are not competitive. Instead, a few countries adjust output to satisfy buyers at the prevailing market price. These producers will happily accommodate index fund investors and pension fund managers as prices rise."