Wednesday, May 18, 2011

Coming to grips with the price of oil.

The announcer on the radio gave the news: Oil prices fell back below $100, as the dollar strengthened….

That the price of oil would be a newsworthy event was not new. Since the OPEC oil embargo and gas lines of the 1970s, periodic high oil prices have made news, as they crimped the American pocketbook, and caused cascading political consequences.

Last week, faced with the economic and political consequences of high gas prices, President Obama sidled up to the Drill, Baby, Drill camp and offered his support to measures to support domestic oil production. Increased domestic oil exploration and production is probably a good idea. After all, the U.S. is the largest consumer of oil, and both our national security and economic security would be enhanced by reduced dependency on oil imports.

This, of course, has been the bi-partisan stance of presidential administrations dating back at least to the Nixon administration. And in terms of environmental impact, opposing oil production in the United States is not necessarily a laudable stance—if one's concern is about global environmental impact—as production in Nigeria, for example, is certainly subject to lower environmental standards than would apply in South Dakota or Alaska.

But the President's call for increased domestic production and exploration did not reflect new insights on U.S. energy policy or how oil dependency affects our foreign policy and military engagement. The President, of course, was responding to the price of gasoline at the pump.

This is a cyclical political script dating back forty years, which is pulled out of the can when gas prices rise. We need more production. We need more conservation. We need alternative sources of supply. Wind. Solar. Tar sands. Horizontal drilling. Hydraulic fracturing. The stuff we learn in those moments of pump price political pandering.

The issue reached an extreme during the 2007-08 presidential primary season when oil prices surged upward. The candidates and political parties fulminated in high lather about cause and effect, supply and demand, and ultimately who was to blame for our pain. As Goldman Sachs predicted $200 oil, candidates vacillated between calls to eliminate the gas tax, to tax the speculators driving up the price or to drill, baby, drill.

Then the price collapsed.

Months before the economy came unglued in the fall of 2008, crude oil prices came back to earth. After peaking over $145 around July 4th, the price was back below $100 by Labor Day, and continued down. All the talk of drilling and T. Boone Pickens wind farms died away. This time, the storm abated before any legislation could be passed, so there was no new ethanol fiasco. No new oil shale tax credits. No new market distorting initiatives put in place by lobbyists for one industry or another seeking an opportunity to benefit from the public’s fleeting attention.

Months later, the Commodity Futures Trading Commission settled the question of whether the price spike was driven by real or speculative demand. Outside of the public view, and far from the political limelight, the CFTC concluded that speculation was indeed the major factor in the price spike, as distinct from "natural" forces of supply and demand driven by economic growth and declining reserves.

That is to say, demand for the consumption of oil was not the driver, but instead it was demand for oil contracts as a financial instrument.

This conclusion is a salient one for our nation's energy policy, and our monetary policy as well. It may seem to be a peculiar feature of the modern economy that commodity price speculation drives the welfare of families and individuals. But whether it is the American family planning a summer vacation or a fruit vendor far away in Tunisia, the prices of commodities traded in Chicago and other financial capitals do indeed touch daily life in the real world.

This is not news. And it is not a modern day phenomenon, as commodity price speculation and hoarding have afflicted daily life throughout history, and Tunisia’s was not the first government to fall due to high food prices. Just ask Marie Antoinette. What is notably today is the direct linkage between currency trading and commodity markets.

Oil prices fell back below $100, as the dollar strengthened….

As illustrated in the graph below, oil today has become the new asset class for hedging against dollar risk in global trading. Today, the U.S. dollar stands alone as the reserve currency of the world economy—the currency that nations use for investing their own reserves and for denominating commodity and other transactions. Despite efforts—such as the creation of the euro—to supplant the dominance of the dollar, no alternative has emerged. The structural flaws of the euro were exposed in the 2008 collapse, as the U.S. Federal Reserve emerged as the sole backstop for the global financial system. Japan’s economy remains weak and threatened by an aging population. The renminbi will not be a real currency for global trading purposes until China is willing to relinquish its managed peg and expose its economy to real market forces.

As shown here, oil has become a nearly perfect hedge against fluctuations in the dollar. The peak price of oil—the red dashed line—in the summer of 2008 came just after the low point of the dollar that same year. The ensuing collapse in oil prices mirrored the rise in the dollar through the early months of the financial collapse. Then the price of oil moved upward—mirroring the rally in gold—as the dollar value declined once again in the wake of Federal Reserve policy driving liquidity into the banking system and the dollar downward through early this year.

Then finally, as announced on the radio, the dollar is now rallying in anticipation of the end of QE2, and the oil price rise has abated.

The linkage between monetary policy and oil prices raises questions for how a consistent domestic energy policy can be implemented if critical energy market price signals are distorted by linkages with monetary policy. Federal energy policies are presumably designed to spur investment into energy development—oil, gas and alternatives—but the such investments rely on the reliability of market pricing as an indicator of supply and demand equilibrium. If oil pricing increasingly reflects non-supply and demand factors, and is in part influenced by Federal Reserve policies and actions, there are significant ramifications for our energy policies.

In simple terms, if the role of oil as an asset class can be expected to significantly affect the price of oil and add to price volatility over time, investors in energy industries will have to consider that volatility and those characteristics as much as actual supply and demand for energy as they consider investment decisions.

The impact of the evolution of oil from a physical to a financial commodity is far reaching, as the decline in the value of the dollar and the correlated rise in oil pricing has most adversely impacted those nations whose currency is tied to the dollar.

China is grappling with that challenge now. By adhering to a dollar peg and declining to float the renminbi, China has been forced to accept the inflationary consequences of growing energy costs. As illustrated here, cost escalation in the price of oil has been most significant for those whose currency is tied closest to the dollar. Accordingly, India and China saw major spikes in oil prices in their respective local currencies, both in 2008 and this year, as compared the modest impacts in the Euro, and negligible impacts in the Australian dollar.

It may be that with the end of QE2, the dollar will stabilize, and with it the rhetorical drumbeat for new energy policies will subside. But the lesson should be internalized into our national debate over debt and deficits, as this same oil price shock that emerged from deliberate Fed policy to depress the value of the dollar will be visited upon us with greater ferocity should global bond markets finally give up on our ability to put our fiscal house in order, and leave us with a decline in the value of the currency—and accelerating energy costs— that is out of our control.

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