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Over the past two years, the price youve paid for a gallon of gas has ranged from

an average of $1.60 to $4.11. To use an economic term, thats nuts. While the Arab

oil embargo, the Iranian revolution, and the Gulf War, not surprisingly, provoked big

price jumps at the pump, not one of those events caused a two-year round trip as

dramatic as the one weve just seen. And the geopolitical drama that caused the

most recent spike, sending the price of a barrel of crude up to $145 on July 4, 2008?Well, there wasnt one. So why did gas prices leap 100 percent in 12 months only to

plummet to $30 on December 23, and then more than double, to a recent peak of

almost $75 on August 21? And how much will it cost you to fill up your tank in the

coming years?

Whats Driving Prices

There are four major factors that determine oil prices supply, consumption, financial markets,and government policies. What has happened is that what have historically been the fundamentalfactors in pricing the barrel supply and consumption are no longer in the drivers seat. Sothis year, for example, there has been abundant supply and slowing demand, but prices havedoubled. Economics 101 says that shouldnt happen. But it has.

In todays world, oil-price dynamics are different than even 10 years ago, says KennethMedlock, an energy economist at the Baker Institute at Rice University in Houston.

Prices are not just curious; they are wild. From 1999 to 2004, the biggest difference between thehigh and low price in any given year was $16; from 2005 on, the average variance was $52

but in 2008 it was $115. Oil, of course, is not the only commodity that has been frisky; copperhas been even more so this year, and everything from onions to equities has seen massive priceswings. At the same time, investment in commodity indexes, which are heavily weighted in oil,has risen sharply, from about $15 billion in 2003 to $200 billion last year.

And, yes, there is a relationship between increased investment and increased volatility, sospeculators are indeed making a big difference in the oil market, something that has riled uppoliticians here and in Europe, who are concerned that high oil prices could hurt their countrieseconomic recoveries. In late July, the U.S. Commodity Futures Trading Commission heldhearings on what, if anything, to do about that. The CFTC is considering new rules for the oilmarkets.

But before you go out and demand your Congressman ship all those speculators to an oil rig inSiberia, remember that speculation is an essential part of any financial market; the purchase ofany stock, for example, is really an act of speculation on the future prospects of the company.And a larger point is that, like any market, oil operates in a context.

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The Bigger Picture

One reason prices have been rising so strongly this year, for example, is that futures traders are

doing what they are supposed to do anticipating. Just as stock prices anticipate future returns,so do commodity prices. Specifically, traders are betting that the global economy will recoverlater this year, and that the supplies will therefore tighten. There is good reason to believe this iscorrect; world oil production last year was barely above 2004 levels, and there is little chance itis going to shoot up. Rather the opposite: Daniel Yergin, author ofThe Prize: The Epic Quest forOil, Money and Power, and head of IHS/CERA, an energy consultancy, toldNewsweekin earlyJuly that of the 15 million barrels of new net capacity that was supposed to come onlinebetween 2008 and 2014, over half of it is at risk of not happening. Investment in new fields hasnot been robust; when the current overcapacity is sucked up, the gap between supply andconsumption will narrow again, forcing prices up.

On that thinking, $75 per barrel can look like a good bet. Over the last six months, crude-oilfutures have been a proxy on economic growth six months out, concludes Tom Kloza, publisherofOil Price Information Service, a newsletter that tracks the oil market. You can read thesentiment swings out there.

OK, but what about the really speculative speculation, such as the hedge funds, moneymanagers, and banks that have gone into commodities big-time? Looking back, it seems almostcertain that traders chasing paper profits drove some of last years frenzy; $145 oil at a time ofsoft demand and ample supply was nuts, absolutely, says Medlock. Speculators can influenceprice beyond the fundamentals. When a majority of players dont have a physical stake, theytrade on technical indicators psychological numbers. Quite frankly, that is nonsense in a

physical market.

So why oil? Why not something else? Again, think context. Oil is globally traded, dollardenominated, and there is a lot of it. What has happened is that it has become, in effect, afinancial instrument, being used as a hedge against both a falling dollar and inflation. If thedollar weakens, a trader can make money just by keeping the rights to a barrel and selling it asthe greenback sinks. Before 2002, there was a weak correlation between the value of the dollarand the price of oil, but since then, the correlation has been strong. Oil is the antidollar, evenmore than gold, says Sean Brodrick, a natural resources analyst at Weiss Research in Jupiter,Florida. I literally see this relationship on the screens out of the dollar into oil, back andforth.

Then there is the fear of inflation. Date this back to the dot-com stock-market crash of 2000-01and subsequent aggressive easing of monetary policy by the Fed. Concerned by the inflationarypotential, money managers began to hold bigger commodity positions. Now consider the bigspending increases by the Bush administration, plus the hugely expansionary nature of theObama administrations bailout and fiscal policies, combined with historically low interest rates.For those who think all this will be inflationary, the demand for oil and other commodities isgoing to be strong.

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What to Do About It

Given that speculation is one of the villains in volatility, the natural political temptation is towhiplash the oil traders. And naturally, the traders are against any new restrictions, arguing thatthey provide necessary liquidity to the markets, allowing end users like airlines to hedge. The

thing is, the latter seem to be ungrateful for the favor. The Air Transport Association denouncedthe destructive volatility in oil markets at the CFTC hearings on July 28; Delta Airlines (DAL)estimated the 2007-08 oil bubble cost it $8.4 billion. Consequently, position limits that restrictthe number of contracts traders can hold are likely, as are increases in margin requirements andnew requirements to reveal who is trading what and when.

But this will not be enough. Volatility is likely when there is a tight fit between supply anddemand. So the U.S. could also try to create a little more breathing room by reducing itsconsumption of oil and boosting its own production. The one and only certain way to reduceconsumption is to raise prices; from November 2007 to October 2008, during the course of theBig Price Run-up, Americans drove 100 billion fewer miles than the year before. You wont hear

this on Capitol Hill, home to the illusion that conservation and cheap gas can occursimultaneously, but a higher tax on gas could help to stabilize prices. So could opening up moreterritory for drilling. And so would some assurance that there is a plan to finance governmentspending without simply printing money.

Where Will Prices Go From Here?

Oil-price forecasting is not for the humble. The oil market has often made very smart peoplelook pretty stupid. And it is common for several smart people to look at the exact same data andthen arrive at opposite conclusions. Right now, for example, Philip Verleger, a Colorado-based

oil-price analyst, is predicting that prices could dip to the $20 range this year; Goldman Sachs,meanwhile, puts the figure at $85, considerably more than its December guess of $45, but wellbelow its May 2008 prediction of a spike to $200. T. Boone Pickens estimates a 2009 averageprice of $75 and Morgan Stanley, $60.

But over the long term, there is something akin to consensus that the days of cheap oil thatcharacterized most of the 20th century are gone. While new CFTC regulations might cool some ofthe hottest money and that is anything but certain, if the oil markets in London, Dubai, andelsewhere do not follow suit all the other factors argue for higher prices. China and Indiasdesire for oil will only grow, and when the economic recovery comes, consumption will also risein the U.S. and Europe. And the drop-off in investment means that once the current overhang issucked up, demand will rise faster than supply. In this case, Econ 101 does apply: Prices will goup.

Moreover, the regulatory environment will also push up prices. New rules on sulfur content, forexample, will raise demand for sweet crude, which is not as abundant as other kinds of oil.Climate-change legislation could also increase the price of fossil fuels. In the medium and longterm, all indicators point to more expensive energy.

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Wise consumers, then, will act as if prices have already risen, buying more fuel-efficient cars,shifting away from heating oil, and taking commuting distance into account when eyeing realestate. And it cant hurt to have some exposure to energy in your portfolio if you have to payfour or five bucks for a gallon of gas, it might offer some comfort to know youre payingyourself a nice dividend. You might as well get used to it, because $2.50 gas will not be with us

for long.

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