The decline in the value of the dollar is often given as an explanation for the run-up in prices. Over the last five years, the dollar is only down 33 percent against the euro, but the price of oil in euros is 2.3 times higher. For the yen it is 3.1 times the level of 2002. Even from the European perspective, oil prices have more than doubled in the last five years.

It is easy to place the blame for high prices on the rapid growth in Chinese consumption. But equally to blame is the lack of growth in oil production capacity. Since the early 1970s virtually all spare production capacity has been concentrated in OPEC, and in the last five years that has declined by two-thirds.

When analysts or OPEC members mention that oil fundamentals do not justify prices hovering between $90 and $100 a barrel, they are usually excluding spare oil production capacity. In July 2002, OPEC was producing 25.3 million barrels per day, with a production capacity of 31.5 million bpd, leaving it 6.2 million bpd in spare capacity. There was enough spare capacity to cover the combined total export loss of any two OPEC members (excluding Saudi Arabia). All but two of OPEC’s 11 members were producing below capacity.

However, by July 2007, OPEC’s numbers were up to 28.6 million bpd in production, but its production capacity was at 31.0 million bpd and spare capacity had dropped to just 2.4 million bpd. Furthermore, most of that current spare capacity is in just one country: Saudi Arabia. In 2002, the Saudis had 37.5 percent, with the remainder spread among eight other members; by last July, the Saudis’ share of OPEC’s spare capacity had jumped to 79.3 percent. The continuing decline in spare capacity adds yet more uncertainty. By November 2007, decreases in OPEC production had reduced the spare capacity cushion to a meager 1.6 million bpd.

The lack of sufficient spare capacity to weather even one major supply interruption has added a supply interruption risk premium to the price of crude oil. Add in the weaker dollar and you have two major factors behind five years of ever increasing oil prices. With little spare capacity, supply interruption risks are amplified, and are likely responsible for about a third of the $90 price we are seeing now.

The potential for supply disruptions are the usual suspects: Nigeria, Iraq, Venezuela, and of course, Iran. For the first two countries, the risk of rebel violence is the key issue. For Venezuela, it continues to be the unpredictability of the Chávez regime. As for Iran, a military intervention by the U.S. or Israel continues to be a worry. Whether retaliatory attempts would be made by the Iranians to block the Strait of Hormuz is an open question. It is unlikely they would be successful. But for some period the perception of risk alone would drive prices well past $100. In a market that moves with perceptions and headlines, any remark that implies an escalation of tensions can move oil prices.

A weakening U.S. economy continues to pose the greatest downside risk to prices. Despite the relatively good report on third quarter GDP, there are few economists who expect the good news to continue. Housing will have a greater impact on the U.S. economy than many think. The end of the housing bubble will dry up a major source of consumer cash. Declining home values will impact holiday spending, and tighter credit combined with those lower home values means cashing in on home equity is a thing of the past for most homeowners.

In addition, few new homes will be built, and that will affect the economy in the coming quarters. Homes are one of the few things left that are truly made in America. There were 963,000 single-family housing starts in September, just a little more than half as many as the 1.83 million housing starts at the beginning of last year. Total starts, which include apartments, were no better at 1.19 million, down 1.1 million units from last January. The residential housing industry will be less than half its former size by the end of this year.

The Household Survey of Civilian Employment showed a loss of 257,000 jobs in October. Wage and salary employment numbers tend to lag in a recession and have not yet turned down. Recessions cause low oil prices and it’s clear that the U.S. economy is headed for a slowdown. We have recession risk but it is yet to have a significant impact on the oil market. If America’s economic problems spread to the rest of the world, there is little doubt that the slower growth will result in more surplus capacity and oil prices could easily drop to $60 per barrel.

There is increased pressure on China to float the yuan, which would certainly slow its growth rate as it would likely make its exports more expensive, particularly the ones headed for the U.S. China is unlikely to maintain its current rate of growth in the face of a U.S. recession.

Could a global slowdown lead to an increase in excess spare production capacity? Oil field development takes many years and is capital intensive. That means that big projects, particularly offshore ones, are seldom abandoned if prices fall. A global slowdown, combined with a surge of new production coming onstream in places like Angola and elsewhere, could mean a significant amount of excess capacity, and that could drive prices down.

Thus, there is plenty of support for both bullish and bearish sentiment when it comes to oil prices. It is entirely possible that we will see $120 and $60 in 2008. Be prepared for either.

James L. Williams is the president of London, Arkansas-based WTRG Economics.