By John W. Schoen Senior producer
updated 10/16/2007 3:54:15 PM ET 2007-10-16T19:54:15

With oil prices touching new highs above $88 a barrel Tuesday, the financial markets and the economy seem to be largely unfazed — at least so far. And despite the rapid run-up in the cost of crude from about $60 just two months ago, motorists have been watching pump prices fall. What’s going on here?

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The question is all the more puzzling because, while strong demand and limited production have kept oil supplies tight for much of the decade, current inventories appear to be adequate to keep the market supplied. U.S. inventories have been falling recently but remain above the five-year average level for this time of year.

Crude oil deliveries to refiners, meanwhile, have been declining as they usually do this time of year when demand for gasoline makes its seasonal move downward following the end of the summer driving season. Retail gasoline prices have fallen from the peak of $3.22 a gallon in May to $2.76 a gallon as of this week, according to the Energy Department.

To be sure, some consumers are beginning to feel the pinch. The price of heating oil is expected to rise more than 16 percent this winter, although a mild winter could send prices tumbling again as they did last January.

“Our (crude) inventory situation is pretty much in line with where it’s been,” said George Winslow, a heating oil dealer in Manchester, N.H. “So you scratch your head and say, ‘Why is the price where it is?'”

One big reason for this apparent paradox is that much of the run–up in prices is being fueled by demand from investors, not consumers. Investors have stocking up on oil futures for a variety of reasons. Earlier this summer, many were betting a strong hurricane or two in the Gulf of Mexico could lead to Katrina-like supply cutoffs to the U.S. market.

More recently, worries have centered on events in the Middle East.  Published reports that the U.S. was considering attacks on Iran’s nuclear facilities have helped sparked fears of a potential supply shortage, said Bill O’Grady, an energy analyst at A.G. Edwards.

“There are a number of things pointing to that possibility,” he said. “Thus, it makes sense to buy oil as a protection against such an event.”

O’Grady says that investors have another reason to stock up on oil: as a hedge against inflation. After recently cutting interest rates to ease a widespread credit crunch — even as inflation remains at the high end of the Federal Reserve's supposed target range — the central bank has shifted its stance to promoting economic growth. That has some investors conscerned about a possible resurgence of inflation, said O’Grady.

“That tells you tell own real assets,” he said. “And the queen of real assets is oil.”

Though many of those who are buying oil in the futures market never intend to actually use it, the impact is very real for those who do. Still the impact on the global economy has been fairly mild — at least so far.

That’s another puzzle for anyone old enough to remember the recession of the early 1980s, which followed a sharp increase in oil prices through the  1970s that peaked with the Iraq invasion of Iran in 1980. Higher energy prices act as a kind of tax on both businesses and consumers. So, all things equal, higher energy prices should slow the economy by putting a drag on both business and consumer spending.

But oil prices have been rising for five years and it hasn’t happened yet, although the price increases have been gaining momentum. From a low of just over $50 a barrel in January, oil prices on the futures market have surged nearly 75 percent. Yet the economy remains relatively healthy, corporate profits are holding up well.

One reason is that economic growth depends less on oil that it did 30 years ago, according to economists, including former Fed Chairman Alan Greenspan.

“We have very gradually but persistently been phasing out oil in the world's gross domestic product,” he said Monday in an interview on CNBC. “The ratio of consumption of oil or energy relative to world GDP, in both developing and developed world, has been declining. And that's one of the reasons why we have been able to maintain fairly strong and buoyant economies in the face of very high crude oil prices.”

By some estimates, it takes about half as much oil today to produce the same dollar of U.S. economic output as it did 30 years ago. So while there are more cars on the road, and bigger houses that consume more energy, more workers today pay for that consumption by, say, working on a computer instead of a job in a much more energy-intensive factory where they might have worked 30 years ago.

And, while the price of oil is at a nominal record, it is still well below the inflation-adjusted 1980 peak of $101.43 a barrel.

Market watchers are split on where oil prices are headed from here. At some point, major moves in any financial market develop enough momentum that they can continue on the same course regardless of what the "fundamental" forces would otherwise dictate. That has some analysts predicting that oil could soon top $100 a barrel.

If the price of oil continues its upward march — especially at the speed it has been moving upward in the last month — the impact eventually will be felt more widely by consumers, businesses and the overall economy. No one is exactly sure where that breaking point lies.

But no market — whether for Internet stocks or Florida condos — goes up forever.

“It will probably come off at some point; I don’t think it’s going to continue to be a runaway freight train,” said Winslow. “But it certainly is doing that now.”

(The Associated Press contributed to this story.)


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