Friday, January 4, 2008 - The Progress & Freedom Foundation Blog

Why does oil cost $100?

Key to "global innovation" -- the name of our new program here at PFF -- are global energy markets. Energy is the basis for life and it fuels all innovation and growth. Most innovations improve energy efficiency -- whether it's an innovation in transportation or information processing, new technologies allow us to do more with less. More output per unit input. But overall, as Peter Huber brilliantly demonstrated in The Bottomless Well, new efficiencies breed wealth, which leads to higher aggregate energy consumption. Global innovation, therefore, requires growing energy supplies.

The whole discussion over the "energy crisis" these past few years has been plagued by a fundamental misunderstanding. The conventional view, regurgitated yet again by Paul Krugman this morning, is that we're running out of oil at the same time Asia is using more of the stuff. Thus, one-hundred-dollar oil.

No doubt the second half of that equation is true, as far as it goes. The Chinese and Indians are big new petroleum consumers. But the prices of nearly all commodities and metals are at or close to all-time highs. Coffee, cattle, carbon-fiber, steel. A decade ago China produced hardly any steel and now it churns out more than any other nation. As demand for most of these commodities has risen, so have the supplies. Increased secular demand from Asia (versus inflationary demand), in other words, might account for a marginal increase in commodity prices, but not the 200-300% jolts we've seen these last few years.

The first half of the conventional equation, moreover -- that we're running out of oil -- is not even close to accurate. There's plenty of oil, and we're discovering ingenius ways to find, pump, and refine more of it all the time, from drilling miles under the ocean bed to cooking tar sands in Canada.

No, the chief cause of high oil prices (and high coffee, milk, copper, steel, and real-estate prices) is the value of the U.S. dollar, which has been weakened by an excessively loose Federal Reserve. Eighteen months ago I called this largely overlooked but crucial factor "The Elephant in the Barrel." That was in the last "energy crisis" of the summer of 2006. Most people dismissed this central monetary factor in all prices at the time, but now the argument has gained much wider support. The Wall Street Journal this morning does a good job explaining this dollar-oil link:

Since 2001 the dollar price of oil and gold have run in almost perfect tandem (see nearby chart). The gold price has risen 239% since 2001, while the oil price has risen 267%. This means that if the dollar had remained "as good as gold" since 2001, oil today would be selling at about $30 a barrel, not $99. Gold has traditionally been a rough proxy for the price level, so the decline of the dollar against gold and oil suggests a U.S. monetary that is supplying too many dollars.

We would add that the dollar price of nearly all commodities -- from wheat to corn to copper to silver -- are also surging, a further sign of a weakening currency. On Wednesday alone the price of wheat and soybeans increased 3.4% and 2.8%, respectively. That follows a 75% increase in their price in 2007 -- which ran ahead of the oil price, which gained a mere 57% for the year. Neither OPEC nor China caused food commodity prices to rise like this. The main culprit here is a global loss of confidence in Federal Reserve policy and the dollar.

We should pursue all sorts of new entrepreneurial energy technologies -- nukes, solar, hybrids, wind (well, maybe not wind), and, yes, more petroleum and hopefully cleaner coal -- but any rational energy policy must begin by understanding the real price of oil.

posted by Bret Swanson @ 10:58 AM | Energy