The Real Cause of the "Oil Pressure" Pt. 2

In my previous post I identified and discussed a depreciating U.S. Dollar as the initial cause of the soaring price of oil and gasoline. The common criticism received in response to my previous argument is that it does not account for the entire price movement, and also that there is a divergence at times from the inverse correlation of the value of the USD and the price of crude. The explanation I previously provided was not incorrect, it was simply only the beginning of the story.

Once the USD started its firm trend downward oil instantly responded with a firm upward trend for reasons I explained in the prior post. The value of the dollar, however, is not the sole input leading to oil pricing, or the pricing of any commodity, albeit a very important one. The decline in the dollar simply served as a catalyst for the progression of simple economically explainable events that followed. Observe:

As oil prices started their steady climb upwards (because of the dollar), buyers and sellers shifted their positions because their actions are based on their predictions of future values. Individual investors, speculators, professional hedgers and even, to a slightly lesser degree, consumers base their purchasing decisions on where they think prices will be in the future. On the demand side, individual investors and large speculators will only buy, and will buy aggressively, when they believe prices will be higher in the future so that they may sell their investment for a profit. On the buy side (without getting too technical), professional hedgers are employed to buy the commodities that their employer uses as an input for their business at the lowest possible price so profit margins can be maximized. An average American who owns a car as his primary mode of transportation wants to minimize his cost at the pump by buying at the lowest possible price.
For all these circumstances a simple analogy can be used: If you want to buy a dozen apples and you think the price will be lower tomorrow, you will most likely wait to buy. But if conversely you believe that the price of apples will be higher tomorrow you will buy today. If you believe that the price will be significantly higher tomorrow, and continue to rise, you will be inclined to not only purchase the dozen apples you wanted, but as many applies as you can possibly afford, regardless if you intend to eat them or sell them, so you can lock in the lowest price possible.

This causes a shift to the right in the demand curve:

(If this graph is completely foreign to you I highly recommend doing a quick search on basic economics- Econweb provides an excellent explanation of the law of Supply & Demand)

This shift is caused because the expectations of higher prices are creating demand that didn't previously exist. As the graph illustrates, this shift in the demand curve, D1 -> D2, sets the equilibrium price higher, A -> B. These resulting higher prices lead to a further shift in the demand curve which in turn causes higher prices, and so on and so on until something intervenes stopping the cycle. This is only the effect from the demand side.

The response from the supply side when higher prices are expected is the exact opposite. While the buyers all want to act as quickly as possible to buy before the price rises, the sellers want to do nothing at all. If you own the stand selling apples and you know that you can sell the same apples for significantly more money tomorrow you will hold them off the market until tomorrow, and if you believe that the prices will continue to rise significantly you will continue to hold your goods off the market until you believe that the price has peaked.

This causes a shift to the left in the supply curve:

This shift is caused by suppliers holding their supply off the market, S1 -> S2. This causes the equilibrium price to rise from point A to point B. Again, this increase in price leads to a further shift in the supply curve which in turn creates even higher prices as the trend solidifies.

Independently, in each of these circumstances we would see higher prices on increased quantity demanded or decreased quantity supplied respectfully. But in the case of oil prices we are seeing a combination of the two creating this massive hoarding effect, shifting both the demand curve right, D1 -> D2, and the supply curve left, S1 -> S2, causing the price to move upwards significantly, p1 -> p3, while quantity supplied remains the same; q1:
This cycle of higher prices followed by shifts in the supply and demand curves causing higher prices is self perpetuating. Once this cycle is started by something, such as a consistently depreciation USD, it becomes self fulfilling and strengthens as the trend becomes visibly solid. This cycle has been moving at an abnormally fast pace because of the introduction of oil ETFs.

ETFs, or exchange traded funds, track the price of a index such as the S&P500 or in this case a commodity. In 2006, the first oil-tracking ETF was released called the United States Oil Fund traded on the Amex. To put it simply, you can trade shares of this ETF through your normal stock broker, either on the long side or short, each share effectively equivalent to one barrel of light sweet crude oil. However, the buyers of these shares are only really purchasing risk and will never actually take possession of any oil. Today, all it takes to open a brokerage account with a discount broker is a couple hundred dollars, or less, maybe a signature or two, and you are up and running. This is a far cry from the barrier of entry into the futures market where you previously needed to be for any direct exposure to oil.

Now that anyone can effectively buy a barrel of oil with $(insert current price/barrel) and a few clicks, the market is flooded with new demand who previously had no access to buying. This is not only strongly facilitating the hoarding effect that we discussed, but is also creating its own shift in the demand curve in an overwhelmingly over exuberant dot com bubble-esque fashion.

The factors that I have explained in these two posts combined with a myriad of other price drivers: increasing demand, oil being a non-renewable resource, environmental protection, anti-business legislation, a volatile world political climate, etc. are a recipe for short term energy-inflation disaster which is having, and will have, serious consequences.

All this doom and gloom!! I probably have you thinking at this point that I am advocating the immediate abandonment of oil and "going green" with solar, wind, and the like. On the contrary, I have a long term positive outlook on the whole mess. Just the same way that the weakening of the dollar catalyzed the upsurge in oil prices, it can also spark the long fall back down. Everything that I described in this post and the last works the exact opposite to the downside. The dollar gaining 30% of its value back would almost immediately drop oil prices almost by the same amount. This would spark the shifts back to the left in the demand curve and in the same snowball effect way that the prices went up, all the factors would start to combine moving them right back down. I obviously agree that we, as a nation, should be working to become independent of foreign oil, and eventually transition completely to sustainable and renewable resources, but until then the pricing of oil just needs to get back under control. This is not the end of the world, the fed just needs to start supporting the greenback instead of just paying it lip service and then we can enjoy the ride back down.

The Real Cause of the "Oil Pressure"

The recent upturn in gasoline prices at the pump have caused widespread concern among consumers. This in turn has caught the attention of the presidential candidates. Although I agree that the current price of oil, and subsequently gasoline, is far above where it should be, I understand the true driver of these prices. Many of my posts leading up to the election in November will analyze each candidate's claims, rants and proposed actions one by one. I will start today by explaining the true economic causes of our current gasoline prices.

The consensus belief among Americans is that the cause of current gasoline prices is "America's addiction to oil," suggesting that our demand is increasing faster than the supply. This belief is fed by almost every member of the media as well as countless politicians, including the current presidential candidates. Some even elaborate to saying that world's demand for oil, mostly coming from China, is causing a shortage and responsible for the current price levels. Members of the democratic party take the topic a step further and accuse the oil companies of gouging and price manipulation. They in turn use this as an excuse to propose ridiculous taxes on the oil companies, but I will get to that in a subsequent post.

The increase in global demand for oil is an undeniable reality. That being said, this demand increase has relatively little to do with the recent surge in prices. The true driver of the recent oil prices is very simple: the value of the U.S. dollar. This is also true of the rest of the commodities that have seen recent surges, including food. There is only slight simplification needed to make this phenomenon readily understandable for everyday Americans that are not familiar with futures markets.

The prices of commodities, including oil, are denominated in U.S. dollars. Meaning that if you wanted to purchase a barrel of oil, a bushel of corn, or an ounce of gold you would need to pay for it with American currency. It is simple to see then, that when all else is held constant, if the value of the dollar decreases, then the number of dollars you would need to spend to purchase that same barrel, bushel, or ounce would increase by that same amount. This is the concept of inflation. (For those wondering why the CPI, the federal government's primary inflation yardstick, only registered a .3% rise in March while oil saw about a 4.5% rise over the same period, I will explain this dislocation and the problems with that indicator in a subsequent post.)

Take a look at the following charts:

On top is a weekly price chart of the U.S. Dollar Index over the past 2 1/4 years- it tracks the value of the dollar. The lower chart reflects the continuation-adjusted weekly price of the Light Sweet Crude futures contract- the price of oil. It doesn't take an economist to see the obvious inverse correlation between the two. You can see the same inverse relation between the recent chart of the dollar and the prices of most commodities.

This is not at all to say that the weak dollar is the only thing influencing the current pricing of oil. I am simply showing the fact that it is the single largest and most important factor. Now that you see the cause and effect relationship between the value of the dollar and the price of oil we can translate this into gasoline prices.

Shifts in the pricing of crude oil are almost immediately translated into identical moves in the price of refined gasoline on the wholesale end. These shifts then take anywhere from a few days to several weeks to fully reflect in the retail price of gas at the pump. This is because when the retailer, a gas station, receives a new shipment to replenish their supply at a higher price they must sell that gas at a proportionately higher price to maintain their margins. In most cases the gas station will then sell the remainder of that shipment for that price and not make major adjustments in price until they receive their next shipment, hence the price lag at the pump.

With this supply chain in mind, starting with the price of crude oil, let us now make a few calculations. First take a look at the same charts of the dollar and crude oil, respectively, extended monthly over the last 10 years:

Focus your attention to the points highlighted by the red line and the circled areas. This was the end of 2002 and just before oil prices began their long climb up from $30 to $125. Notice that this coincides with the point at which the dollar started its slide from 105 to almost 70. So now let us evaluate the price of oil and gasoline if the dollar was not allowed to depreciate 33%. Take the current price of oil at $125 a barrel and multiply it by .67 to remove the effect of the weak dollar and we arrive at $83.75- the price of oil as dictated by supply and demand. We can then take the national average gas price at the pump of $3.72 and use the same calculation to arrive at $2.49. Granted these prices are still historically high, except when compared to the oil crisis of the early 80's, but the prices we just arrived at are what they would be if the Fed did not allow and perpetuate weak dollar policy. (The dollar and the actions of the Federal Reserve will be recurring topics that I will elaborate on in future posts, I will not go into detail here because the focus of this post is the simple relationship between gasoline prices and the value of the dollar as has been illustrated.)

In conclusion, my goal in this post was to make the reader aware of the real primary driver of current gasoline prices. The main importance being that not one of the 3 presidential candidates has put much, if any, emphasis on strengthening our dollar as a means to getting energy prices back down to acceptable levels. The gas tax holiday, more taxes on oil companies, taking away drilling subsidies, carbon emission caps, none of these proposals or gimmicks will have any real positive effect on long term prices, and some of these will lead to higher prices. My next post will tackle the subject of taxes on oil companies and will build off of some of the ideas we have just covered. The takeaway: as Larry Kudlow states repeatedly, "The candidate that gets to the strong dollar first will get it right and take the presidency."

Welcome to Enlightened Economist

First and foremost this blog will be used to cut through the vast confusion caused by politicians, political candidates, and anyone else that deems themself an authority on the subject of economic-based politics. There will be very few times that I will ever feel the need to comment or offer my opinion on social or moral issues except in the context of economic discussion. I hope to provide an absolutely spin-free insight into the actual causes and effects of economic legislation in addition to a very concise analysis of the global economic climate. I fully encourage any reader that ever disagrees with me to reply to the respective post with a constructive argument. I also highly encourage any reader to elaborate on any of my posts if they feel that I have overlooked or oversimplified something. All questions are always welcomed as well.

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