Sunday, January 6, 2008

This Weekend’s Contemplation #1 – Oil, Gold, and the Dollar

The article below from the WSJ is a good summary of the price of oil in dollars, gold, and euros. Clearly the price of oil is as high as it is because not only to tightening oil supplies, but to a weaker dollar as well. For those of you that remember the oil situation of the 1970s, it looks like déjà vu all over again (to quote Yogi Berra). Text in bold or in parentheses is my emphasis.

Oil prices finally hit $100 a barrel this week, albeit briefly, but breaking through that symbolic barrier is ominous and higher gasoline prices are sure to follow. Supply disruptions in various places and surging demand in China and India are part of the explanation for this decade's upward trend in oil prices. But perhaps the biggest factor has been largely overlooked: the decline in the value of the dollar.

Since 2001 the dollar price of oil and gold have run in almost perfect tandem (see nearby chart). The gold price has risen 239% since 2001, while the oil price has risen 267%. This means that if the dollar had remained "as good as gold" since 2001, oil today would be selling at about $30 a barrel, not $99. Gold has traditionally been a rough proxy for the price level, so the decline of the dollar against gold and oil suggests a U.S. monetary that is supplying too many dollars.

We would add that the dollar price of nearly all commodities -- from wheat to corn to copper to silver -- are also surging, a further sign of a weakening currency. On Wednesday alone the price of wheat and soybeans increased 3.4% and 2.8%, respectively. That follows a 75% increase in their price in 2007 -- which ran ahead of the oil price, which gained a mere 57% for the year. Neither OPEC nor China caused food commodity prices to rise like this. The main culprit here is a global loss of confidence in Federal Reserve policy and the dollar.

This state of affairs is all too similar to what happened in the commodity markets in the 1970s -- particularly the energy markets. Oil price spikes in that stagflationary decade were driven less by OPEC than by the weak-dollar policies pursued by the Fed. Gold in that decade broke from its traditional $35 an ounce mooring and climbed as high as $850 in 1980, before Paul Volcker began to restore the Fed's credibility.

Another way to consider the impact of the weak dollar is to examine what would have happened if the dollar had simply kept pace with the euro in this decade. What would oil cost today? Not $100, but closer to $57 a barrel. The nearby chart gives a sense of the comparative trend since 2000.

A weak dollar has been trumpeted in the business media and especially among manufacturers as a strategy to lower the trade deficit. But this strategy makes imported oil a lot more expensive. The trade figures reveal that a major contributor to the rising trade deficit over this decade has been the high cost of oil imports. We don't worry about the trade deficit -- except in so far as it inspires protectionism -- but those who do might want to consider that the weak dollar policy they are cheering is making fuel very expensive.

We aren't saying that supply problems and an increase in relative demand haven't played a role in oil's rise. Cambridge Energy Research Associates estimates that "aggregate supply disruptions" reduced oil supply by almost two million barrels a day in late 2007, which isn't helping prices. But the high price of oil is not a vindication of theorists who say we are confronting "peak oil."

A report issued this summer by the National Petroleum Council and energy experts across the spectrum concluded that "the world is not running out of energy resources," though it conceded that "there are accumulating risks to continuing expansion of oil and natural gas production from the conventional sources." Daniel Yergin of Cambridge Energy notes that in the energy markets "most of these risks are above ground, not below ground." By that he's referring to the tendency of politicians to intervene in the energy markets in any number of harmful ways. We'd offer barriers to drilling in Alaska and on the Continental Shelf as Exhibit A and B in this country. (I doubt drilling in Alaska or on the Continental Shelf will make that large a difference.)

Rising oil prices act like a tax on American consumers. With the economy slowing, the Fed is now under intense pressure to cut interest rates to stimulate the economy and provide liquidity to the banking industry. But if this causes the dollar to continue to weaken, the tax of higher commodity prices will offset much of the "stimulus" from looser money. The Fed will get a lot less bang for its easier buck.

The larger danger here, as we've been warning for some time, is that the U.S. seems to be returning to the Carter-era economic policy mix of tight fiscal policy (tax increases) and easy money. Add barriers to oil and natural gas production and you have a recipe for higher oil prices and slower growth. In a word, for stagflation. The Reagan-Volcker policy mix of the 1980s changed all that, but maybe we have to relearn the hard way every generation or so what works -- and what produces $100 oil. (One of the issues with a tight fiscal policy and easy money is that the government and the Fed may not have a lot choices left.)

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