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August 7, 2006
The Elephant in the Oil Barrel


A more accurate depiction
would have Federal Reserve
Chairman Ben Bernanke
balancing the oil drum
on his index finger

Nigerian pipeline explosions, Chinese demand, Arab angst, Venezuelan volatility, peak oil, and a pugnacious Putin premium: These are the usual explanations for high petroleum prices. But our discussion of the so-called "energy crisis" has ignored the elephant in the barrel: monetary policy.

Today, high oil prices are the backdrop for Middle Eastern chaos and calls for bad energy policy. It was much the same three decades ago, during the 1970s, when high prices yielded similar violence against our fellow man and against good economics. This is no mere coincidence. A weak dollar is the key culprit, now as then.

. . .

Today, commodity prices across the board, from coffee to cattle to carbon fiber, remain near 25-year highs. High oil prices are not an exception but the rule, not a unique phenomenon driven mostly by geopolitical risk and demand but just another commodity whose price is determined primarily by the value of the dollar.

Expensive oil is not exclusively a monetary event. Risk and demand do matter. But comparing oil to other commodities, especially the key monetary guide of gold, we find that elevated risk and demand explains only $10-$15 of the higher oil price. Something around $30 of the higher price is explained by a weak, inflationary dollar. The entity most responsible for expensive oil is thus the Federal Reserve.

. . .

-Bret Swanson

The Elephant in the Barrel

by Bret Swanson | August 4, 2006

Nigerian pipeline explosions, Chinese demand, Arab angst, Venezuelan volatility, peak oil, and a pugnacious Putin premium: These are the usual explanations for high petroleum prices. But our discussion of the so-called "energy crisis" has ignored the elephant in the barrel: monetary policy.

Today, high oil prices are the backdrop for Middle Eastern chaos and calls for bad energy policy. It was much the same three decades ago, during the 1970s, when high prices yielded similar violence against our fellow man and against good economics. This is no mere coincidence. A weak dollar is the key culprit, now as then.

When Egypt and Syria, backed by the Soviet Union, launched the Yom Kippur war on Israel on October 6, 1973, the price of oil had been rising for two years. For decades, oil's price had been remarkably stable, like the prices of most other goods. But in 1971 President Nixon had broken the dollar's links both to gold and key foreign currencies. The Bretton Woods system and the dollar collapsed, and a decade-long inflation began.

By July 1973, gold had deviated from its long-time price of around $35 per ounce and skyrocketed to $120. Oil, like other commodities, also responded quickly to dollar weakness and doubled in price by the early autumn. The Mid-East nations complained that the Western oil companies were accumulating massive "windfall profits" from these high prices. Having negotiated the "Tripoli and Tehran agreements" in the previous environment of price stability, the Arabs and Persians were stuck with much lower prices and royalty payments. You know the rest of the decade's news: war, embargoes, gas lines, inflation, wage and price controls, hostages.

Some 30 years later high oil prices have empowered Hugo Chavez and Mahmoud Ahmadinejad, among other bad actors and terrorists. High prices do not excuse aggression, but they do help explain it. Columnist Thomas Friedman calls this tendency of oil money to corrupt weak states and embolden irresponsible leaders his First Law of Petropolitics. But Friedman ignores the crucial component of the value of money itself.

Today, commodity prices across the board, from coffee to cattle to carbon fiber, remain near 25-year highs. High oil prices are not an exception but the rule, not a unique phenomenon driven mostly by geopolitical risk and demand but just another commodity whose price is determined primarily by the value of the dollar.

Expensive oil is not exclusively a monetary event. Risk and demand do matter. But comparing oil to other commodities, especially the key monetary guide of gold, we find that elevated risk and demand explains only $10-$15 of the higher oil price. Something around $30 of the higher price is explained by a weak, inflationary dollar. The entity most responsible for expensive oil is thus the Federal Reserve.

For more evidence of the centrality of the dollar's value, consider what happened to oil just several years ago. In 1998 the price of crude plunged to $10 per barrel. At the time, China had been growing at 10% per year for some 20 years, the U.S. economy was growing fast at 4%, and the Middle East was typically if not maximally volatile, with Saddam testing the UN inspection process and the U.S. sending Tomahawks back his way.

Demand and geopolitical volatility were fairly high in 1998, and ominous "peak oil" theories had been around for a while, yet oil was just one-seventh of today's price. Other commodity prices were also at multi-decade lows, with gold sinking below $275 per ounce (versus today's $650). The common factor was a super-strong currency--a severe shortage of dollars. This deflation roiled world markets and bankrupted many companies and nations with dollar debts: Thailand, Indonesia, Korea, Turkey, Argentina.

The deflationary dollar sent a struggling but oil-rich Russia over the edge into default. Russia today supposedly has some magical power to set world prices, yet in 1998 oil was $60 less expensive, and a desperate Russia was helpless to achieve higher prices. Even by 2002, after the traumatic events of 9/11 and America's take-down of the Taliban, oil still traded at around $20 per barrel. Adjusted for inflation, this was the price of oil in 1970--and in 1960, and 1950.

Then the Fed started making inflationary mistakes. Alan Greenspan's liquidity injections after 9/11 had mercifully relieved the deflation of 1997-2001, but the Fed then overdid it. By leaving interest rates at 1% for far too long in 2003-04 and then raising interest rates far too slowly through 2006--even though the economy and commodity prices had long since recovered--the Fed weakened the dollar and juiced oil prices.

The Fed can make these mistakes because it watches old data like the personal consumption expenditures (PCE) deflator, possibly the most backward looking of all price indicators. It can take five years or more before Fed actions find their way through the web of global commerce and contracts and finally show up in the PCE deflator. The dollar weakening of 1985-86, for example, did not cause a peak in measured inflation until 1990. By then the damage was done.

People say oil supply-lines are "tight," but that's what happens with all goods in an inflationary environment. Buyers buy before prices further rise. Monetary velocity, or the turn-over of currency, takes off. It looks like there are "shortages," but in fact there is only a shortage at the old price. The opposite happens with a strong, or deflationary, dollar. As currency becomes more valuable, more dear, buyers hold on to the money, waiting for cheaper prices later. Velocity plummets. The apparent result is "gluts" of goods. Markets and supply-lines appear "loose."

Because dollar weakness, or inflation, hits commodities first but eventually filters through every product, service, and asset in the world economy, high oil prices won't yield as much real wealth to suppliers tomorrow as today. The prices of things they can buy with oil money will have risen as well. Rogue oil nations will thus not enjoy as much of a relative power increase as it might appear today. Alternative fuel sources and schemes, supposedly now "in play" because of high oil prices, also become less economically feasible if most of the increased oil price is due not to a permanent oil shock but to dollar devaluation. Moreover, if the Fed gets control of the dollar, the price of oil could fall substantially. It is these periods of transition, where the value of the currency is changing fast, but before price changes filter through all commerce and contracts, when financial and political disruptions often take place.

Today, a third oil flash point dominates our thinking. In addition to Mid-East violence and bad energy policy, we are told there is a new global race to secure scarce resources. It is the kind of zero-sum struggle that some believe could lead to the world wars of the future, often pointing to some inevitable clash between the U.S. and China. A keener understanding of currency and energy will be required to avoid such a zero-sum disaster.

There is no inherent shortage of oil. Not now, and not tomorrow. One tiny shale formation right in America's backyard--the 1,200 square mile Piceance Basin of western Colorado--contains some 1 trillion barrels of oil, more than all the proven reserves in the world. Vast open spaces across the globe remain unexplored or untapped.

None of this is to say we don't need more energy from more diverse sources. We do. We need more oil, gas, and coal, much more nuclear to power an increasingly electricity-centric economy, hopefully solar, and maybe someday hydrogen and even deuterium from the seas. We should encourage the entrepreneurial pursuit of a range of new technologies. But basing our energy policies on a supposed shortage of oil or a misunderstanding of why the oil price is so high could severely jeopardize our economy and international security.

If we stabilize the dollar and unleash exploration and technology, we can reap the economic and political windfalls of abundant energy.
______________________________

Bret Swanson is a senior fellow at Seattle's Discovery Institute.

Dotted Divider Line





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