I couldn't repair your brakes, so I made your horn louder
—Stephen Wright
I don't know why the oil markets chose June 6th, 2008, to freak out1. The upward price movement started the day before, but Thursday's rise was within the bounds of "normal" single-day volatility lately. On Black Friday, the NYMEX WTI price jumped up nearly $11/barrel during the call-out trading session between 9:30 AM and 2:30 PM EST.
A spate of bad news appears to have "caused" the price hike, but can we honestly say that any of these concerns, or even all of them put together, was extraordinary? Was there a profound shift in the market fundamentals? The answer is "no"—anxieties in the skittish market turned to full-blown panic. The fear-driven stampede reflects the high degree of uncertainty in the markets about the continuing devaluation of the dollar, conflict in the Middle East, unfettered oil demand growth in China and the Middle East, lagging supply growth, and last but not least, the poor health of the American economy.
Worries about America's Stagflation Show include soaring (and understated) inflation, future Fed interest rate policy, rising unemployment, the reeling housing market, huge write-downs in the financial community, soaring trade & federal deficits, and the price of corn.
Nobody can find solid ground to stand on, the magical price point that brings supply & demand into balance. Can this oil price spike go on? Yes, indeed it can. Is oil in a speculative bubble? Mostly not, but there may be a downward market "correction" at some point.
The only thing I can think of that would dampen the oil price at this point would be a a few large hikes in the Fed funds rate to deprive the economy of all the inflationary oxygen making oil traders giddy. (It might also help to close the Enron "loophole" as George Soros wants to discourage market speculation.)
Rate increases would curtail loans (and thus investment) in an already recessionary economy, thereby defending the dollar and taking some of the bite out of inflation by reigning in growth in the M3 money supply (St. Louis Fed). The current M3 number is unavailable because this data series has been
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An even slower economy would eventually put a large dent in American oil demand, an "involuntary" decrease dictated by ruthless "free" market principles. Our beloved Fed Chairman, "Helicopter Ben" Bernanke, is now hinting that inflation and the dollar are a concern. But this is an election year, and the fallout (joblessness, business failures) from raising interest rates would no doubt be severe.
The oil market fundamentals still predominate over other factors affecting the oil price. Among the other detrimental things driving up the price, untangling the relationship between the oil price and the declining dollar seemed most important because understanding this issue yields the most bang for the buck (least?) in terms of understanding why we are oppressed by soaring oil prices.
The Dollar Devaluation/Oil Price Death Spiral
If the relative value of the dollar falls X% and oil is denominated in dollars on the world market, the oil price must rise X% to keep its value. This is the simple numéraire interpretation of what is driving the oil price upward as argued, for example, in What's Going on in the Oil Market? (Daily Kos, June 7th, 2008). Econbrowser's Menzie Chinn discusses the issue in Does Dollar Weakness 'Cause' High Oil Prices? (October 31, 2007).
A causal flow is imputed in this discussion: namely dollar weakness causes the price of oil to rise, because oil is denominated in dollars. In the face of a declining dollar, with the relative price of oil being set in equilibrium, the dollar price of oil must rise...
The Dallas Fed's energy update for the 2nd quarter shows that the dollar has continued to slide, "propping up ... oil prices even further" (graph left).
The price differential between the euro and the dollar is dramatic. Only 75 euros (€ 75) were required to purchase a barrel of oil when this snapshot was taken, whereas the U.S. dollar price was $119/barrel.
All things being equal, if the dollar's value declines, the oil price will rise. But not all things are equal. Menzie Chinn created a similar, updated graph to put the price issue in perspective (Econbrowser, June 6, 2008).
One way of taking out some of the numéraire issue is to see how a price of a barrel of oil would be, expressed in other currencies. In the figure below, I compare the dollar price against that in euros, and against that in the Special Drawing Rights (SDR)...
What [Chinn's figure, like the one above] highlights is that while USD weakness is associated with higher dollar prices for oil, upward trends in all prices are evident...
The oil price expressed in euros has also risen sharply since the beginning of 2007, but not nearly so quickly as the dollar price in 2008. Another look the graph above reveals that a strong inverse correlation between the dollar's relative value and the oil price is only apparent since the 2nd quarter of 2007. The longer term relationship is not nearly so straightforward (See Chinn's "Dollar Weakness" article).
... the idea that it's just a numéraire issue -- weak dollar implies more dollars per barrel of oil -- does not seem to be consistent with a negative correlation between the real price of oil and the real value of the dollar, plotted in [the graph above left]
Other factors complicate the numéraire explanation. Chinn points out the two-way causality between the value of the dollar and the dollar price of a barrel of oil. "A higher relative price of oil should weaken a country's real exchange rate if it worsens the country's terms of trade." If a country is a large net importer of oil—like the United States—the trade gap worsens as the oil price rises (graph left). The U.S. News & World Report cites the increasing trade gap as a cause of the declining dollar (March 7, 2008).
The ongoing trade deficit for goods and services—which stood at more than $700 billion in 2007—has played a role as well. Although it has narrowed recently, the gap works to increase the supply of dollars in the global financial system, which pulls the currency lower.
If expenditures on imported petroleum exceed export gains due to a weaker dollar, the trade deficit grows worse. The Wall Street Journal's Oil Prices Pushes Trade Gap Wider updates the deteriorating situation (June 10, 2008).
The U.S. bill for crude oil imports in April increased. It totaled $29.34 billion, up from $25.03 billion in March. The average price per barrel increased by $6.96 to a record $96.81 from $89.85. Crude import volumes increased to 303.05 million barrels from 278.57 million.
The simple explanation put forward at the Daily Kos (and elsewhere) that the dollar devaluation is the primary cause of the oil price rise since the middle of 2006 is only part of the story. Dollars and oil are traded in separate markets which are not always mutually reinforcing, and causes are hard to separate from effects.
Nonetheless, the Dallas Fed's Crude Awakening estimates that "exchange rate movements accounted for roughly a third of the $60 increase in oil prices from 2003 to 2007." It's only in the last few months that matters have got out of hand as the devalued dollar/higher oil price dynamic spirals out of control.
The declining dollar has other detrimental macroeconomic effects on the oil markets according to the Dallas Fed.
A declining dollar makes oil cheaper for Europeans and other foreign consumers, propping up their demand. A weakening U.S. currency also reduces the dollar-denominated supply from foreign producers. Together, these two factors exert additional upward pressure on prices. Daniel Yergin, chairman of Cambridge Energy Research Associates, adds a third element in arguing that some investors have used oil as a hedge against the dollar’s decline.
It is indisputable that investors have used oil (and other commodities) "as a hedge against the dollar's decline", an obvious fact that we don't need Daniel Yergin to tell us. Moreover, speculation in the futures markets is playing a role, although on the last day of the trading period for the front month, you've got to sell or take delivery on the oil (CNBC video). Nobody appears to be hoarding oil, so the oil price on the last day of the front month contract is the market-determined price, speculators or not.
The Dallas Fed's other contentions are more doubtful. I am not aware of any country or oil company withholding oil from the market because the dollar's value is declining. Even within OPEC, little spare sellable oil capacity exists. Saudi Arabia and the rest of OPEC are following their own production policies as detailed in Sleepwalking Toward the Oil Precipice (ASPO-USA, April 30, 2008). Fuel protests in Europe contradict the idea that the declining dollar is propping up demand there. Oil is not "cheaper" for Europeans, who must also bear heavy fuel taxes.
Consumers Caught in the Middle
The declining dollar/rising oil price death spiral leaves consumers subject to escalating prices for fuel, food, and just about everything else. Dow Chemical's across-the-board price increase of up to 20% on all of its products signals that inflation is now out of control. The dollar's devaluation means we must pay more for imported goods in addition to paying the higher costs engendered by rising oil prices. The spending outlook is bleak for the large majority of Americans caught in the middle of this price squeeze.
Will there be an oil price "correction" that brings relief to struggling Americans? When the price spikes as it did on Black Friday, the jump is not related to market fundamentals. At today's price of $133/barrel, the "bubbly" (non-fundamental) part of the current price may be as much as $25-$30/barrel, which puts the new "floor" price for oil in the $105-$110 per barrel range. However, no large price correction is possible unless at least two of the following three conditions are met—
- the U.S. dollar regains much of its strength relative to the euro and the yen
- the crude oil supply exceeds the modest gains it has made so far this year
- subsidies on oil consumption are lifted in the Asian economies, especially China
I'll leave you to judge whether you think these conditions will be met any time soon. And remember this: any downward price "correction" that does occur is likely to be short-lived.
People concerned about "peak oil" usually give short-shrift to other economic considerations. Being essentially a (very) special-interest group, most of the attention goes to the lagging oil supply, and most of the supply discussion focuses on geology and depletion. It is important to remember that we are dealing with multiple failures regarding America's status in the global economy, although our perilous oil dependency will ultimately be foremost among them.
Contact the author at dave.aspo@gmail.com
Notes
The term "Black Friday" has been applied to various single-day economic panics in American history. For example, the Fisk-Gould scandal in 1869. Only recently has been the term been debased to refer to the shopping binge on the day after Thanksgiving.
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