Rising Oil Prices and the Falling Dollar
Henry C.K. Liu

This article appeared in AToL as Flat-Earther Blind to Oil Facts on  June 28, 2008
Celebrated New York Times columnist Thomas L. Friedman, a flat-earthling, in a provocative polemic (Mr. Bush, Lead or Leave, June 22, 2008) accused the president of the United States of being the nation’s addict-in-chief to oil with “a massive, fraudulent, pathetic excuse for an energy policy.”  He described the president’s strategy as getting “Saudi Arabia, our chief oil pusher, to up our dosage for a little while and bring down the oil price just enough so the renewable energy alternatives can’t totally take off. Then try to strong arm Congress into lifting the ban on drilling offshore and in the Arctic National Wildlife Refuge.”
Friedman admits that “we’re going to need oil for years to come.” But he said that for geopolitical reasons he prefers the US getting as much oil as possible from domestic wells. He also admits that “our future is not in oil.” He wants the president to tell the country an allegedly much larger truth: “Oil is poisoning our climate and our geopolitics, and here is how we’re going to break our addiction: We’re going to set a floor price of $4.50 a gallon for gasoline and $100 a barrel for oil. And that floor price is going to trigger massive investments in renewable energy — particularly wind, solar panels and solar thermal. And we’re also going to go on a crash program to dramatically increase energy efficiency, to drive conservation to a whole new level and to build more nuclear power. And I want every Democrat and every Republican to join me in this endeavor.”
Friedman talks as if he wants the president to be an autocratic dictator. Does Friedman not know that with $4.50 gas and $100 oil, a large number of working people will not be able to make ends meet with their current income, or retirees on social security will not be able to heat their homes this winter? Airlines and other transportation companies would face bankruptcy? Does he not know that in a democracy, sustained $100 oil translates into a serious political problem? The oil problem does not lend itself to simplistic solutions. Yet that is precisely what our flat-earthling proposes.
Even multinational corporations are being forced to raise prices to ward off losses from high energy costs. For example, Dow Chemical (NYSE: DOW) has just announced it will raise the price of its products by as much as an additional 25% in July, on top of the 20% increase in June, in an effort to offset the continuing relentless rise in the cost of energy and hydrocarbon feed stocks. The Company also will implement a freight surcharge of $300 per shipment by truck and $600 per shipment by rail, effective August 1, 2008.
Furthermore, Dow is temporarily idling and reducing production at a number of manufacturing plants, having reduced its ethylene oxide production worldwide by 25%, and idled 30% of its North America acrylic acid production. Dow also will idle 40% of its European styrene production capacity, and has reduced its European polystyrene production rate by 15%. In light of a sharp decline in auto sales, Dow’s Automotive unit is announcing a series of cost reduction measures covering facilities, people and external spending, divesting its paint shop sealer business and is implementing plant consolidations resulting in the closure of three production units. In addition, Dow Building Solutions temporarily idled 20% of its European capacity for producing STYROFOAM insulation.  Earlier this month, Dow announced plans to idle three Dow Emulsion Polymers plants representing 25% of North America capacity and 10% of European capacity related to declines in the housing and consumer sectors, as well as rising costs.

Andrew N. Liveris, Dow chairman and CEO, described the steps as “extremely unwelcome but entirely unavoidable” as the global cost of oil, natural gas and hydrocarbon derivatives surge ever higher, despite company efforts to improve energy efficiency by 22% from 1995 to 2005, and to target another 25% by 2015, to cut costs significantly, and with an array of efforts around alternative energy and alternative feed-stocks. Over the past five years, Dow’s bill for hydrocarbon feed stocks and energy has surged four-fold, from $8 billion in 2002 to an estimated $32 billion-plus this year. 
General Motors announced plans to close four plants manufacturing trucks and SUVS, citing decreased sales of large vehicles in the wake of rising fuel prices. Ford took similar actions.  Yet about 65% of oil consumption is related to transportation, a sector where alternative fuel technology is relatively easy to tackle, with alternatives such as electric and substitute fuel engines.
In China, steelmakers were forced to agree to a record increase in annual iron ore prices in a move likely to boost the cost of cars, machinery and other products globally. Chinese millers agreed to pay Anglo-Australian miner Rio Tinto up to 96.5% more for their ore supplies this year, the largest ever annual increase and ten folds the 9.5% increase paid in 2007, surpassing the record increase of 71.5% in 2005 when the commodities boom began to gather pace. The development fuels fears that global commodity-led inflation will continue. Anglo-Australian BHP Billiton, the world’s largest primary resources company, said the 96.5% record increase in iron ore cost announced by Rio Tinto was not enough, signaling it could ask for a rise above 100% with its steelmaker customers.
In South Korea, Pohang Iron and Steel Company (Posco), the third largest steel producer in the world, increased prices by up to 21%, taking the cumulative price inflation to about 60%. German steelmaking giant Salzgitter A.G, successor company of Reichswerke Hermann Göring of the Third Reich, also said it would raise prices by 20%.
In my May 26, 2005 article in Asia Times on Line: The Real Problem with $50 Oil, I laid out the economics and geopolitics of oil. The main points are updated below to show the impact of a $100 floor for oil as proposed by Friedman.
It is unfair of Friedman to label Saudi Arabia as “our chief oil pusher”. Since Arabs are also Semites, one is tempted to point out that Friedman opens himself to accusations of anti-Semitism when he picks on Saudi Arabia unfairly.
The world’s oil problem began in 1973 when OPEC, having formed in 1960, emerged as an effective cartel after the Arab oil embargo against the US, Western Europe and Japan for supporting Israel in the Yom Kippur War. The embargo started on October 19, 1973, and ended on March 18, 1974. During that six-month period, the price for benchmark Saudi Light increased from $2.59 in September 1973 to $11.65 in March 1974. Since then, OPEC has been setting bottom benchmark prices for its various kinds of crude oil in the world market, with Saudi Arabia as swing producer to increase or decrease supply to stabilize prices. To keep oil price at the $100 floor proposed by Friedman, the cooperation of Saudi Arabia is needed to reduce production whenever oil price drops below the $100 floor. By that standard, Saudi Arabia can hardly be called a “chief oil pusher”.

By 1984, the effects of a decade of higher oil prices had affected US demand in the form of better insulated homes and more energy-efficient industrial processes, and in substantial improvement in automobile fuel efficiency, not to mention new competitive use of cleaner coal, wind and solar and other alternatives. At the same time, crude-oil production was increasing throughout the world, stimulated by higher prices. During this period, OPEC total production stayed relatively constant, around 30 million barrels per day. However, OPEC’s market share was decreased from more than 50% in 1974 to 47% in 1979. The OPEC loss of market share was caused by non-OPEC production increases in the rest of the world. Higher crude prices caused by OPEC production sacrifices had made exploration more profitable for everyone, not just OPEC, and many non-OPEC producers around the world rushed to take advantage of it, including the US.

Global demand for oil had peaked by 1979 and it became clear that the only way for OPEC to maintain prices was to reduce production further to compensate for the high production of non-OPEC producers. OPEC reduced its total production by a third during the first half of the 1980s. As a result, the cartel’s share in world oil production dropped below 30%. Non-OPEC producers, including the US, got a big lift from higher prices, larger market shares, and an expanded definition of proven reserves which expanded as oil prices rose.
After two decades of high prices, oil dipped below $10 per barrel after the Asian financial crisis of 1997 as demand fell when the global economy stalled. After oil prices peaked above US$58 a barrel in early April, 2005, the White House announced that it wanted oil to go back down to $25 a barrel. When oil rises above $50 a barrel and stays there for an extended period, the resultant changes in the economy become normalized facts. These changes go way beyond fluctuations in the price of oil to produce a very different economy. I listed in 2005 ten new economic facts created by $50 oil. I now adjust these facts for $100 oil as proposed by Friedman to see if his proposal makes sense. The key fact is that while $100 oil may stimulate development of alternative energy modes, such development cannot be expected to bring oil price back down, or the stimulated alternative energy sector will go bankrupt. While there is no known solution to the oil problem that will lead to lower oil prices short of a global recession, $100 oil is not without problems.

Fact 1: Oil-related transactions involving the same material quantity involve greater cash flow, with each barrel of oil generating $100 instead of $25. The United States consumed in 2007 about 22 million barrels of oil each day, about 25% of world consumption of 87 million barrels. China consumes 7.3 million barrels per day. Yet daily world production is only about 85 million barrels, leaving a deficit of 2 million barrels which are being made up from inventory. This fact is the fundamental reason why oil prices have risen. It can be expected that production will increase as a result of high prices to remove the supply deficit. US consumption has been fairly constant in the past few years. About 10.2 million barrels were imports and only 5.5 million barrels from OPEC. At $100 a barrel, the aggregate oil bill for the US comes to $2 billion a day, $730 billion a year, about 5.6% of 2007 US gross domestic product (GDP). About 50% of US consumption is imported at a cost of $1 billion a day, or $365 billion a year. Oil and gas import is the single largest component in the US trade deficit, not imports from Japan or China.

As oil prices rise, consumers pay more for heating oil and gasoline, truckers pay more for diesel, airlines pay more for jet fuel, utility companies pay more for fuel as coal price rose with oil prices, petrochemical companies pay more for raw material, and the whole economy pays more for electricity. Now those extra payments do not disappear into a black hole in the universe. They go into someone’s pocket as revenue and translate into profits for some businesses and losses for others. In other words, higher energy prices do not take money out of the economy, they merely shift profit allocation from one business sector to another. More than $365 billion a year goes to foreign oil producers who then must recycle their oil dollars back into US Treasury bonds or other dollar assets, as part of the rules of the game of dollar hegemony. The simple fact is that a rise in monetary value of assets adds to the monetary wealth of the economy.

Fact 2: Since energy is a basic commodity and oil is a predominant energy source, high energy cost translates into a high cost of living, which can result in a lower standard of living unless income can keep up. High energy cost translates into reduced consumption in other sectors unless higher income can be generated from the increased cash flow. Unfortunately, pay raises typically have a long time lag behind price increases. Higher prices translate into higher aggregate revenue for the economy and explain why corporate profit is up even when consumer discretionary spending slows. A large part of the oil problem comes from the fact that higher corporate revenue from rising prices has failed to translate into higher wages.
Fact 3: As cash flow increases for the same amount of material activities, the GDP rises while the economy stagnates from wage depreciation. Companies are buying and selling the same amount or maybe even less, but at a higher price and profit margin and with employees at lower pay per unit of revenue. As oil price rose within a decade from about $10 a barrel to $150, a 15-fold increase, those who owned oil reserves see their asset value increase also 15 folds. Those who do not own oil reserves protect themselves with hedges in the rapidly expanding structured finance world. Since GDP is a generally accepted measure of economic health, the US economy then is judged to be growing at a very acceptable rate while running in place or even backwards. There is an expanding oil bubble, albeit smaller than the recently collapsed housing bubble, if one understands that a bubble is defined as a price regime that has risen beyond an economy’s ability to sustain it with compensatory income from wages.

Fact 4:
With asset value ballooning from the impact of a sharp rise in energy prices, which in turn leads the entire commodity-led price chain in an upward spiral, the economy can carry more debt without increasing its debt-to-equity ratio, giving much-craved support to the residual debt bubble that began to burst before oil prices began to rise. Since the monetary value of assets tends to rise in tandem over time, the net effect is a de facto depreciation of money, misidentified as growth.

Fact 5: High oil prices threaten the economic viability of some commercial sectors, such as airlines, trucking and motor vehicles, which have exhausted their price elasticity. These sectors cannot pass on increased cost without causing their sales volume to fall. Detroit, namely Ford and General Motors, with their most profitable models being the gas-guzzling trucks and sport utility vehicles (SUVs) that can now take more than $300 to fill their tanks, are going down the same distress route as their under-funded pension obligations.

Fact 6:
Industrial plastics, the materials most in demand in modern manufacturing, more than steel or cement, are all derived from oil. Higher prices of industrial plastics will mean lower wages for workers who assemble them into products. But even steel and cement require energy to produce and their prices will also go up along with oil prices. While low Asian wages are keeping global inflation in check through cross-border wage arbitrage, rising energy prices are the unrelenting factor behind global inflation that no interest-rate policy from any central bank can contain. Ironically, from a central bank's perspective, a commodity-led asset appreciation, which central banks do not define as inflation, is the best cure for a debt bubble that the central banks themselves created with their loose money policies. Since most assets are exponentially larger than the rate of consumption, the wealth effect of higher asset value can neutralize the rise in consumer prices. This is the key reason why central banks are not sensitive to the need to keep wages rising.  The monetary system is structured to work against wage earners who do not own substantial assets.

Fact 7: War-making is a gluttonous oil consumer. With high oil prices, America’s wars will carry a higher price, which will either lead to a higher federal budget deficit, or lower social spending, or both. This translates into rising dollar interest rates, which is structurally recessionary for the globalized economy operating under dollar hegemony. But while war is relentlessly inflationary, war spending is an economic stimulant, at least as long as collateral damage from war occurs only on foreign soil. War profits are always good for business, and the need for soldiers reduces unemployment. Fighting for oil faces little popular opposition at home, even though for the United States the need for oil is not a credible justification for war. The fact of the matter is that the US already controls most of the world's oil without war, by virtue of oil being denominated in dollars that the US can print at will with little penalty. Petro-war is launched to protect dollar hegemony which requires oil to be denominated in dollars, not physical access to oil. Much anti-war posturing in an election year is merely campaign rhetoric. Military solutions to geopolitical problems arising from political economy will remain operative options for the US regardless who happens to be the occupant of the White House, populist or not.

Fact 8: There is a supply/demand myth that if oil prices rise, they will attract more exploration for new oil, which will bring prices back down in time. This was true in the good old days when oil in the ground stayed a dormant financial asset. But now, as explained by Facts 3 and 4 above, in a debt bubble, oil in the ground can be more valuable than oil above ground because it can serve as a monetizable asset of rising value through asset-backed securities (ABS) in the wild, wild world of structured finance (derivatives). So while there is incentive to find more oil reserves to enlarge the asset base, there is little incentive to pump it out of the ground merely to keep prices low.

Gasoline prices also will not come down, not because there is a shortage of crude oil, but because there is a shortage of refinery capacity. The refinery deficiency is created by the appearance of gas-guzzlers that Detroit pushed on the consuming public when gasoline at less than a $1 a gallon was cheaper than bottled water. Refineries are among the most capital-intensive investments, with nightmarish regulatory hurdles. Refineries need to be located where the demand for gasoline is, but families that own three cars do not want to live near a refinery. Thus there is no incentive to expand refinery capacity to bring gasoline prices down because the return on new investment will need high gasoline prices to pay for it. After all, as Friedman tirelessly reminds us, the market is not a charity organization for the promotion of human welfare. It is a place where investors try to get the highest price for products to repay their investment with highest profit. It is not the nature of the market to reduce the price of output from investment so that consumers can drive gas-guzzling SUVs that burn most of their fuel sitting in traffic jams on freeways.

Fact 9: According to the US Geological Survey, the Middle East has only half to one-third of known world oil reserves. There is a large supply of oil elsewhere in the world that would be available at higher but still economically viable prices. The idea that only the Middle East has the key to the world’s energy future is flawed and is geopolitically hazardous.

The United States has large proven oil reserves that get larger with rising oil price. Proven reserves of oil are generally taken to be those quantities that geological and engineering information indicates with reasonable certainty can be recovered in the future from known reservoirs under existing economic and geological conditions. According to the Energy Information Administration (EIA), the US had 21.8 billion barrels of proven oil reserves as of January 1, 2001, twelfth-highest in the world, when oil price was around $20 per barrel. These reserves are concentrated overwhelmingly (more than 80%) in four states - Texas (25%, including the state's reserves in the Gulf of Mexico), Alaska (24%), California (21%), and Louisiana (14%, including the state's reserves in the Gulf of Mexico).

US proven oil reserves had declined by about 20% since 1990, with the largest single-year decline (1.6 billion barrels) occurring in 1991. But this was due mostly to the falling price of oil, which shrank proven reserves by definition. At $100 a barrel, the reserve numbers can be expected to expand greatly. The reason the US imports oil is that importing is cheaper and cleaner than extracting domestic oil. At a certain price level, the US may find it more economic to develop more domestic oil instead of importing, but the formula depends more on price gap between import and domestic oil which in a global market is not expected to stay wide for long. The idea of achieving oil independence as a strategy for cheap oil is unworthy of serious discussion.
The economics of petroleum is as important as geology in coming up with reserve estimates since a proven reserve is one that can be developed economically. But it is important to remember that political economy extends beyond the supply and demand fixation of market fundamentalists. If the Middle East and the Persian Gulf implode geopolitically and oil from this region stops flowing, the US, as an oil producer will be a main beneficiary of $50 oil, or $100 oil, or even $1,000 oil, as would Britain with its North Sea oil and countries such as Norway, Indonesia, Nigeria and Venezuela. But the biggest winner will be Russia. For China, it would be a wash, because China currently imports energy not for domestic consumption, but to fuel its growing export machine, and can pass on the added cost to foreign buyers. In fact, the likelihood of the US bartering below-market Texas crude for low-cost Chinese manufactured goods is very real possibility in the future. Similar bilateral arrangements between China-Russia, China-Middle East/Gulf, China-Nigeria, China-Venezuela and China-Indonesia are also good prospects. Also, China’s off-shore reserves have so far stayed largely undeveloped.

Fact 10: Fifty dollar oil bought the US debt bubble a little more time, but bubbles never last forever and it burst in August 2007. But in a democracy, the White House in 2005 was under pressure from a misinformed public to bring the oil price back down to $25, not realizing that the price for cheap oil could accelerate the bursting of the debt bubble. Despite all the grandstand warnings about the need to reduce the US trade deficit, a case can be made with ease that the United States cannot drastically reduce its trade deficit without paying the price of a sharp recession that could trigger a global depression.

The Economics of Oil

Since the discovery of petroleum, its economics has never been about cutting a square deal for the consumer, corporate or individual, let alone the little guys or the working poor. It has to do with squeezing the most financial value out of this black gold.

John D Rockefeller consolidated the US oil industry into a monopoly by eliminating chaotic competition to keep the price high, not to push prices down. Neo-classical economics views higher prices of consumables as inflation, but asset appreciation is viewed as growth, not inflation. Since oil is both an asset and a consumable commodity, neo-classical economics faces a dilemma in oil economics. The size of oil reserves is exponentially greater than the annual flow of oil to the market. What is even more fundamental is that as the flow of oil to the market decreases, the price of oil goes up, enlarging proven reserves by definition. Thus while a rise in the market price of oil adds to inflation, the corresponding rise of the asset value and size of oil reserves create a wealth effect that more than neutralizes the inflationary impact of market oil prices. The world should not care about an few added percentage points in inflation if the world’s assets would appreciate 100% as a result, except that when oil is not owned equally among the world’s population, a conflict emerges between consumers and producers, making oil a domestic political and geopolitical problem.

In fact, on an aggregate basis, cheap oil can have a deflationary impact on the economy by reducing the wealth effect of all assets. For the US economy, since the United States is a major possessor of oil assets, both on- and off-shore, high oil prices are in the national interest. What we have is not an inflation problem in rising oil prices, but a pricing problem that distributes unevenly the benefits and pains of price adjustments among oil owners and oil consumers, both domestically and internationally. This is a political problem. Politicians are under populist pressure to keep oil prices low when the solution is to equalize the benefits and pain of high oil prices.

Oil Price and Monetary Policy
Failure by the Organization of Petroleum Exporting Countries (OPEC) to cut production at its meeting in November 1998 prompted prices to collapse to a 12-year low of $10.35 a barrel in New York the following month. A combination of excess production, rising inventories and poor demand for winter heating fuels pushed prices down. In March 1999, oil prices climbed 17%, going higher as oil-producing countries, unified by low prices, succeed in cutting output. Oil prices began making a sharp recovery in the late winter of 1999, rising from the low teens at the beginning of the year to more than $22 a barrel by the early autumn, and crossed $30 a barrel in mid-February 2000. A major cause was production cuts settled upon in March 1999 by OPEC and other major oil-exporting nations.
On March 12, 1999, St Louis Federal Reserve Bank president William Poole said in a speech that the growth of the US money supply, which was then at more than 8% when inflation was below 2% annually, was “a source of concern” because it outpaced the rate of inflation. The M2 money supply had been growing at an 8.6% annual rate for the previous 52 weeks to keep the economy from stalling before the 2000 election. The US Federal Reserve was also watching the rate of inflation, held down mostly by low oil prices.
Poole warned that “we cannot continue to rely on the decline of oil prices at the [low] pace of the last couple of years.” He said investors who had pushed bond yields to their highest level in six months were correct in assuming the Fed’s next move would be to increase interest rates. The Fed Open Market Committee (FOMC), when it met on February 2, 1999, had left the Fed Funds rate (FFR) target unchanged at 4.75%. Poole voted in 1998 for the FOMC to cut the FFR target three times between September and November to 4.75% when oil was at $12.

Today, with oil at around $135, the FFR target is 2% effective since April 30, 2008. On June 25, the Fed opted for keeping the Fed funds rate target unchanged. In its statement, the Fed Open Market Committee (FOMC) said: “Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.”
Annualized growth rate for M2 in Q4 2007 was 6.8%, with a Fed funds rate target of 2%, as compared with the 1999 M2 growth rate of 8.6% against a Fed funds rate target of 4.75% in response to fallouts from the 1997 Asian Financial Crisis. However, in the past seven quarters before end of 2007, V2 (the velocity of M2) declined by 2.3% annum rate, causing GDP growth to decelerate from 3.5% to 2.2%. GDP growth for Q1 2008 was 0.6% which justified a 2% Fed funds rate target.
Yet if the Fed is really concerned with fighting inflation expectation, $135 oil and 2% Fed funds rate target simply do not mix, even with a falling money-supply growth rate. There is strong evidence that instead of worrying about inflation expectation, the Fed is really more worried about the economic debris from the burst debt bubble, which stealth inflation through asset appreciation is expected to help clean up with less pain. If high oil prices are the handiwork of speculators, the Fed is the speculator-in-chief. But there is very little speculation in the oil market because hedging is not speculation as all competent market analysts know. The rise in oil price is the direct result of a debasement of money coordinated by the world’s central banks led by the Fed.

In July 1993, when the US economy had been growing for more than two years from M2 growth of over 6%, Fed chairman Alan Greenspan remarked in congressional testimony that “if the historical relationships between M2 and nominal income had remained intact, the behavior of M2 in recent years would have been consistent with an economy in severe contraction.” With the M2 growth rate down to 1.44% in July 1993, Greenspan said, “The historical relationships between money and income, and between money and the price level, have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place.”

Yet M2, adjusted for changes in the price level, remains a component of the Index of Leading Economic Indicators, which some market analysts use to forecast economic recessions and recoveries. A positive correlation between money-supply growth and economic growth exists only on inflation-adjusted M2 growth, and only if the new money goes into new investment rather than as debt to support speculation on rising asset prices. Sustainable economic expansions are based on real production, not on speculative debt.

In 2004, longer-term interest rates actually declined from their June high of 4.82% to 4.20% at year-end even as short-term rates rose in a “measured pace” to 2.25% in December 2004 (from all time low of 1% in June 2003 to 5.5% in June 2006), with the 2004 money supply growing at a 5.67% annual rate. This reflected a credit market unconcerned with long-term inflation despite a sinking US dollar and oil prices rising above $50 a barrel. The reason is that $50 oil raised asset value at a faster pace than price inflation of commodities. $100 oil only doubles the impact.

In March 2000, OPEC punctured the Greenspan easy-money bubble by reversing the fall of oil prices. The FOMC was forced to respond to the change in the rate of inflation, no longer being held down by declines in oil prices. Because the easy money had stimulated only speculation that did not produce any real growth, the easy-money bubble of 2000 evolved into the next debt-driven asset bubble in housing that burst in August 2007. The smart money realized in 2000 that the market’s march toward $50 oil was on, as the smart money realized in 2007 that the march towards $150 oil was on. And in 2005, $50 oil appeared to be giving Greenspan’s debt-driven asset bubble a second life, most of which ended in the real-estate/housing sector. If oil should fall back to $25 a barrel as the White House wanted, the debt-driven asset bubble would have popped with a bang.
As it turned out, the housing bubble burst from a credit collapse in August 2007 that the Fed under Bernanke tried to bail out with massive liquidity injection and oil went on to $130. The Fed now appears to be assuming that oil prices will soon subside, based in large part on information on futures prices. Yet there are limits to the extent to which futures prices can indicate price trends, since arbitrage prevents them from moving very far out of line with current prices.

There was solid evidence that the 1970s recycling of petrodollars, which mostly ended up in the dollar assets in the United States anyway, contributed to US inflation as much as the higher retail price of gasoline. It in essence siphoned off additional global funds to purchase higher-priced oil for investment in US real estate, which was the only sector the then unsophisticated Arab money managers thought they knew enough about to handle. By the 1990s, they were more sophisticated. Some had expected that a new injection of petrodollars would sustain the collapsing “new economy” equity market of the 1990s. It did not work because, even at $35, oil was still behind its pre-1973 price relative to the peak Nasdaq in June 1999, the equivalent of which would bring $120 oil.

The drop in oil prices after 1997 was mostly a cyclical effect of the drastic reduction of demand from the Asian financial crisis, which impacted the whole world. There was zero pressure even in the US to raise oil prices at that time, because of the effect they had on keeping easy-money inflation low. Even oil companies were not really upset by this temporary condition because, until oil prices dropped below $7 per barrel, it was not a big deal since that was the offshore production cost in the North Sea. The wellhead cost on land was less than $4 per barrel, plus market-induced leasehold costs. North Sea oil was higher because of fixed offshore drilling investments. In 1998, oil could stay at anywhere above $7 for quite a few years without doing any lasting harm to the US or Europe. It was widely expected to go back up to $35 by the end of 2000, and a lot of people would get rich in the process. OPEC was touting the line of argument that high prices would stimulate new exploration to get the non-OPEC consumers to accept costlier oil. In the long run, less new exploration would be good for OPEC. Before 1973, the whole world was happy with $3 oil. As for the US, cheap oil kept inflation (as measured by the Fed) low, the dollar high and dollar interest rates low. These benefits outweighed the oil-sector problems created by a collapse in oil prices. In oil, no one has told the truth for more than 80 years, or since its discovery.
The problem with cheap oil

It is often overlooked that the United States is a major oil producer. In fact, before the discovery of oil in the Middle East in the 1930s, the US was the world’s biggest exporter of oil. “Oil for the lamps of China” was a slogan of the Standard Oil monopoly. It is not clear that cheap oil is in the national interest of the US. Cheap oil distorts the US economy in unconstructive ways. In recent years of cheap oil, advances in conservation have all been abandoned. Until this year, US consumers were buying eight-cylinder SUVs with 400 horsepower that deliver only six miles per gallon in urban traffic, as well as air-conditioned convertibles. Even with $4 gasoline, commuters face only a $1,000 annual increase in their gas bills. Vehicle prices have risen faster than gasoline prices in recent decades. Of course, the rest of the world outside the US has been operating on $4 gasoline for a long time.  

Hundred-dollar oil is not an economic disaster but it is a political problem. Hundred-dollar oil needs not be damaging to the global economy, but it nevertheless forces a restructuring of the global economy in ways that have political reverberations. To begin with, $100 oil will in the long run stimulate more exploration and production, and reactivate idle wells that are uneconomic at $10 per barrel. It will also make alternative energy economically more viable. Also the global economy is growing more energy-efficient with new technology and the effect of oil price on the economy is much less than in the 1970s. And $100 oil will prevent a return to the era of abusive waste of energy caused by excessively low oil prices. Just as low wages encourage misuse of labor, unreasonably low oil cost creates incentives for misuse of energy and discourages the search for alternative energy sources.

The only trouble is that $100 oil takes money from the pocket of consumers and delivers it to the oil producers (not just Arabs), who then reinvest it in Wall Street. The net result is a transfer of wealth from the “working families” of the world to the capitalists the world over. Consumer demand will shift, with more money spent on fuel and utilities and less for other types of consumption that improve the standard of living, but equity prices will rise because there will be more dollars chasing the same number of shares. What is more troubling is that the appreciation of the resultant enlarged proven oil reserves will fuel more debt at the same debt-to-equity ratio. The current structure of the overcapacity economy is such that more debt can only go to support consumption and speculative, not productive, investment, causing a new unsustainable debt bubble.

A reduction of oil taxes will leave more money in consumers’ pockets. Governments can make up the resultant tax shortfall by increasing tax rates on oil-asset appreciation - perhaps, in the case of the United States, to fund the coming Social Security shortfall. But governments tend to resist fuel-tax reduction because of the flawed ideology that fuel taxes encourage conservation. Capital-gain tax measures are resisted on the doctrine that what hurts capital hurts the poor also, if not more. This ideological fixation is increasingly inoperative in a world saddled with overcapacity and widening income disparity. Any development that reduces demand is deadly for the current global economic structure. Therein lies the key issue of the coming oil crisis - ballooned equity prices unsupported by wage income and a dampening of consumer demand due to high prices. The world enjoyed a boom from $10 oil for a decade. During that boom, income disparity increased both domestically and globally. Now, a return to operative market price for oil should not be allowed to continue this trend of widening income disparity.
I wrote in 2005: “We now appear to be heading toward a replay of the early 1980s when a widening trade deficit and a precipitous fall of the dollar triggered the 1987 collapse of the equity markets. Greenspan’s strategy of reducing market regulation by substituting it with crisis intervention is merely swapping the extension of the boom for increased severity of the bust down the road. Greenspan appears to be looking to $50 oil to sustain his debt bubble. While $50 oil is not a problem in the long run, it could give Greenspan a super-size headache if it serves merely to fuel more debt. Greenspan started his tenure at the Fed with a market crash. Will the wizard of irrational exuberance end his tenure with another market crash?” My question was answered two years later by the 1997 credit crisis which even the Fed now is saying the market would not see a bottom until the end of 2009.
June 25, 2008