The Price of Oil

I - correction we - are watching the drama of the investment banking crisis unfold. Yet the media, chasing its most recent opportunity to increase ad sales revenue, has become virtually mum on the issue of oil. Prior to September 25th every other story had to do with the price of oil and the effects on the economy. the "R" word (Recession) was bandied about as a foregone conclusion.

Here, in the midst of this new, bigger "crisis", I heard one reporter throw out this statement, "If Congress doesn't come to a quick resolution to sure up the credit markets we will definitely be pushed into a recession." Maybe the oil "crisis" wasn't so bad afterall! That makes this a great opportunity to take a more pragmatic look at "The Price of Oil".

The stories of price fixing and colusion within the oil industry have been told so loudly that Congress actually held hearings on the matter. You don't need a smoking gun for the conspiracy theories to fly all over the place. We, as a people, tend to love our conspiracy theories. Probably because we so love a good story.

Because of its importance in our day-to-day lives, oil is a very special commodity. Gold is nice but its price can easily be tied to the value of the dollar and serves as a hedge against inflation.

Corn seems to be getting a lot of attention but that has more to do with government regulation on the rate of ethanol production versus the amount of land being devoted to it. In fact, prior to the new governmental regulations, farmers had been devoting more and more acreage to the production of soybeans and corn prices had mimicked the typical supply/demand scenario with adequate supply for the marketplace.

Perhaps because of its importance in our day-to-day lives, pricing oil is not a straightforward process. In fact, pricing oil has roots in four key areas.

The Supply/Demand Ratio.
Due to the equity lines established with higher home values we have had the luxury of buying bigger: cars and homes to begin with. And buying more stuff - gas, appliances, furniture, gizmos, do-dads, gadgets, whatever.

With the exception of oil, much of this stuff came from China. More and more native Chinese have moved from rural farming regions to the cities to take advantage of the increased demand for labor and higher wages. The price of oil and gas in China remains artificially low through the use of two mechanisms: a fixed currency and goverment subsidy. From a manufacturing standpoint, that combination helps to keep wholesale prices lower allowing increased production in China and increased consumption in the United States.

China wasn't alone in the increased demand for oil. India too emerged as a global powerhouse using its well-educated, cheaper workforce to provide outsourcing services to mid- and large-size corporations in western Europe and the United States. Naturally this economic evolution brought with it an increase in demand for oil with no offsetting reduction within the more developed economies. In fact, gas climbed to $4.00+ per gallon before evidence emerged that folks were gradually changing their habits with respect to the use of various fuel products.

The Speculators.
There has, for the first time that I can remember, been a lot of talk about speculators in the marketplace. This perhaps, is the most complicated piece of the puzzle. In the simpliest terms, speculators range from individuals like you and me to larger interests such as hedge funds that buy and sell oil futures contracts anticipating that the price of oil will increase or decrease according to the laws of supply and demand. [By the way, this extends to all types of commodities including metals, currencies, grains, dairy products, etc.]

Speculators basically feed off the price action that results from the producers that sell and the distributors and large consumers (i.e. airlines) that are buying to meet current and future demand. Speculators will sell their positions before the contract due date. In other words, they do not take delivery of the product. All other players intend to deliver or receive the product according to the purchase price paid.

In this current economic cycle, large speculators such as hedge funds exploited a loophole. You see, large speculators are typically limited to the number of contracts that they can buy at any given time. So, they found a work-around: sell other assets - i.e. stocks - but instead of receiving cash, they took the equivalent dollar value in oil futures contracts.

Remember that commodity markets are a zero sum game. For every winner there is a loser. The markets are cash settled at the close of business every trading day. Speculators enter the market expecting an increase in capital. However their presence also helps to insure that price fixing does not occur between the producers and distributors.


The Value of the Greenback.
You may not realize this but the U.S. Dollar is the reserve currency of the world. That means oil - like gold - is priced in U.S. Dollars. You might be paying in Euros, Japanese Yen or whatever but you'll be paying the equivalent sum of U.S. Dollars. Now, between 2001 and 2008 the U.S. Dollar has slid from $1.20 to .75 cents against other currenices - a 62.5% decline. Over the same period oil has increased from $20.00 to $140.00 per barrel! That increase, as I've outlined, is a combination of factors including the value of the greenback.

Recent rallies of the Dollar have helped to abate the price of oil somewhat. This despite recent threats by Iran and the presence of hurricanes in the Gulf of Mexico.

The Fear Factor.
How much oil is out there? I mean really. Do you know? Does anyone "know"? I know there is something called "proven" reserves. I know that there's oil in the Arctic, in Alaska. And, I know that oil companies are still discovering ways to find and extract oil. Yet, fear of the unknown is a very powerful motivator. For example, after the 9/11 terrorist attacks, open market purchases were made to increase reserves held by the U.S. Government.

In this particular round of price increases fear of high oil and gasoline has enticed people to buy smaller cars, swap out standard lightbulbs for energy efficient models, increase the purchase of solar and other alternative energy products. In fact, this year we coined the term "staycation" to describe vacations that people are taking close to home rather then flying or driving great distance. All of this, by the way, has played a part in GDP growth for the year. Necessity remains the mother of invention.

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Mind you, nothing here is "ground breaking". These forces have always been at play and will remain so. Speculation may have run a bit higher because of some hedge funds that found a loophole to exploit but, in some respects, that's their job: to increase returns on their client's investments. There's nothing new there and, in a growing economy, that kind of action is normally applauded. Still, there are some politicians and media types calling these funds to task. And, just for good measure, they want to call the oil companies to task. Their gambit: the Windfall Profits tax. The idea of which is to tax profits above a "normal" limit. Now, I don't know what constitutes normal, who defines it, what timeline they use, or any other criteria they may use. But I do see problems with the tax.

To begin with, companies don't sit on profits. They don't leave that money in the bank to collect dust and interest. They put it to work. Among other things oil companies would probably use those profits to maintain and improve existing systems; on R&D - i.e. to discover new sources for oil, systems to extract oil safer and more efficiently, alternative energy systems; and to reward executives at the helm when those profits were earned. [Hell, everybody wants to take their money away when a company flounders, they should get extra when their company does well. Don't you think?]

Taxes on profits would have the unintended effect of producing less. I mean, if I'm Exxon and the government tells me I'm going to be hit with a Windfall tax, I might as well produce just enough to avoid the tax. Right? Of course there would be those unintended consequences: since 70% of GDP in this country is generated by consumers purchasing goods and services extra taxes would thwart economic growth. You would also face increased shortages at the gas and oil pumps. In the land of supply and demand that means higher prices for all oil products on a permanent basis.

In short, A Windfall Profit Tax may make a nice headline but it's a longshot that will probably never see the light of day regardless of who is elected President or, which political party controls the Congress.

I was talking to a friend of mine recently. He said, "I think the problem is deregulation of the power industry." My take is that bureaucracies move at a snail's pace. They are not designed to react aggressively to positive and negative changes in the economy like the consumer can. We have seen evidence of that with the "Staycations" that I mentioned before. Sure, it's inconvenient, painful even. We don't like to make the adjustments. So, we appeal to the government and ask them to make it better for us. Given the choice, I'd rather rely on the wisdom of the individual versus the collective bargaining of the United States Congress.

Please email your comments and questions to billmazzacca@gmail.com