An Easy Fix to the Oil Price Problem

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This article was originally publish on July 1, 2011

On Wednesday, June 22nd, the price of oil (NYSE:USO) closed at $95.41. The following day President Obama announced to great fanfare the release of 30 million barrels of crude over the next 30 days from the Strategic Petroleum Reserve  with an eye on reducing oil’s price.

Mildly sentient minds with a basic sense of oil-price history knew it wouldn’t work, and sure enough, one week later – yesterday – oil closed at $95.25. As of today oil is trending down to $94/barrel, but this can be chalked up to Treasury Secretary Tim Geithner’s looming resignation. As this piece will make abundantly clear, the price of oil is a dollar phenomenon, and with a weak dollar Treasury Secretary getting ready to depart, gold (NYSE:GLD) is down $19/ounce in concert with increased dollar strength, thus helping to explain oil’s slight weakness relative to yesterday.

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What’s perhaps not so fascinating or surprising about the turn of events in the past week has been the response from those who should know better. Those in the oil/economic commentariat still deluded by the false notion that the oil price is a supply phenomenon cheered Obama’s decision while trotting out “studies” from Goldman Sachs (NYSE:GS) and other oil-price insiders saying that the release of new supply to make up for an alleged Libyan shortfall would bring down the price of a barrel.

Oh well, markets are nothing if not forward looking and with more oil set to come online, there’s been no discernable change in the oil price; something anyone who understands the dollar’s outsized impact on the price of a barrel could have told them. Much as the oil (NYSE:USO) supply and “Drill Baby, Drill” crowd would like to simplify the price of crude down to more drilling and more barrels, we’ve never had an oil scarcity problem. We have, however, suffered periods of dollar weakness that have boosted the nominal cost of a barrel.

Separate from the oil-supply (NYSE:USO) crowd are the national security types who feel that major stockpiles of “American” oil are necessary in case of a “supply emergency” wrought by war. Their view is that in a time of war oil producers could “embargo” us, and the U.S. economy would suffer oil-supply shortfalls that would hamper our ability to successfully fight our battles. This group’s economic illiteracy is even more impressive.

To understand why it has to be remembered that oil is a commodity like any other, and there’s no accounting for its final destination. To put it very simply, the U.S. could be at war with every oil-producing nation in the world, it could have embargoes placed on it by every one of those oil-producing nations, yet Americans and our military would still consume that oil as though it had bubbled up in West Texas.

Despite this basic truth, many in our midst still believe strongly that producers of raw materials can somehow hold us hostage to their production. The view is not worth dignifying, though long ago Joseph Schumpeter did. Addressing commodity-security worriers around the time of World War II, the great Austrian economist mocked “This almost childish belief that so many people hold…that by means of managing raw materials you can force foreign nations to their knees.” It “has been a boon to autarchists, militarists, and dictators all over the world.”

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If Schumpeter is doubted, note how U.S. presidents have needlessly prostrated themselves before Saudi Arabian princes going back at least to FDR. When George W. Bush was photographed holding hands with his Saudi counterpart in Crawford early in his administration, this bit of sucking up reached a new, hurl-inducing low.

Arguably the reason that so many still buy into the “energy security” argument has to do with the still widely held belief that Japan invaded the U.S. in 1941 because we’d cut off their supply of “American” oil and steel. Nothing could be further from the truth.

Though we tried to “embargo” Japan, no different than any other country, U.S. oil producers still couldn’t account for the final destination of their production. As Schumpeter’s wife Elizabeth correctly observed about the U.S. prohibition of steel and oil exports to Japan, they “were not likely to work. Japan could carry on its war with China (NYSE:FXI) by getting these materials from other sources”; or better yet “American” oil and steel (NYSE:X) from the individuals U.S. producers were trading with.

The better, rarely discussed reason for Japan’s invasion of the U.S. in 1941 has to do with the barriers we put up to Japan’s trade with their natural trading partners. Specifically, Washington made trade more difficult for the Japanese with India, French Indo-China, and the Philippines; those markets crucial to Japanese (NYSE:EWJ) producers. When goods can’t cross borders, armies often do…

Going back to the more modern Arab oil “embargo” in 1973, U.S interests imported more oil in 1973 than they did in 1972, and in 1974 they brought in more oil than they did in 1973. Embargoes are a silly mirage, but also a dangerous one given how fear of what is purely symbolic often captivates policy types.

Back to the price of oil, contrary to false signals wrought by a commodity priced in a floating dollar, the real price of oil has always been remarkably stable. Priced in gold (NYSE:GLD), the most stable measure of value known to mankind, oil’s price has remained mostly the same over the last 40 years. An ounce of gold bought 15 barrels oil in 1971, 15 barrels in 1981, and it buys 15 barrels today.

For evidence, readers need only look at the below chart which shows that in the 24 years leading up to 1971 (when President Nixon tragically severed the dollar’s link to gold) when the dollar had a gold definition of 1/35th of an ounce, the price of oil was cheap and stable. But once that relationship was abolished, the dollar began floating, and with it, the nominal price of oil. Considering the two decades of “oil shocks” in the 1970s and the last 10 years, we didn’t experience oil shocks as much as the dollar collapsed in value, and a commodity priced in dollars spiked.

The good news is that there’s an easy fix to our oil problem, which is a dollar problem. If we redefine and strengthen the dollar, the price of oil will fall substantially to a very stable level. In short, we don’t have a supply problem that can be fixed by more crude exploration, but we do have a weak dollar, and until its decline is arrested, oil will remain expensive no matter the amount of oil brought to market.

John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.

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