Wednesday, June 8, 2011

Gold vs Crude Oil

GOLD vs CRUDE OIL
Oil producers normally find it in their best interest to add steadily to productive capacity. Gradual addition of capacity year after year keeps oil supply in rough equilibrium with demand as the global economy grows. Mild shortages and surpluses sometimes arise, but they are quickly addressed by market forces so long as monetary policy is anchored properly. It was really a monetary error that began throwing the oil market out of whack three years ago, one we wrote about at the time in forecasting a sharp decline in the price of oil. Specifically, it was the sharp deflation of the U.S. dollar which began in 1997-98. As the value of the dollar rose into deflationary territory -- as measured against gold, the best proxy for commodities, many countries were forced to break their dollar links and devalue their currencies. This triggered major global disruption, first in Asia and then in Latin America. 

As global economy slowed, oil demand plunged, leaving an excess of oil on the market, which caused oil to fall harder and faster than gold or the currencies tracing the dollar. As the oil price fell to $10/bbl in 1998/99, oil producers at the margin were driven out of business. Those that remained stopped investing in infrastructure and production. Once the world economy adjusted to the deflation, in 1999, global growth resumed. Governments in Asia and Latin American began to find the keys to growth, stabilizing their currencies and jettisoning some of the austere fiscal policies pressed upon them by the IMF and World Bank. The rebound in commerce quickly increased the need for oil. Demand began to exceed available inventories, pushing prices up and out of their traditional trading locus. Had oil producers at the margin not been totally destroyed by the 1997-98 commodity depression, no supply shortages would have emerged.

The oil price should come back down as high prices pull capital towards higher relative returns, which implies more production -- but the process will take a while. The 1997/98 oil price plunge had a searing effect on producers, who obviously do not want to be burned again, should another deflation be right around the corner. Oil producers may not have identified price swings as monetary deflation, but they certainly grasped the concept that committing to new fixed capacity is more risky in an environment where the nominal price is highly volatile. As long as the dollar is not fixed in terms of gold, its volatility will continue to throw off misleading signals of capital shortages and surpluses, inevitably leading to booms and busts. 

Gold and oil traditionally have had a 15-to-1 relationship, only slipping out of congruence for short periods of time. When the gold/dollar relationship is anchored, the oil/dollar relationship remains stable as well. (See the chart of oil pre 1970 – it barely budged for years at a time.) When the dollar/gold relationship is malfunctioning, as it is now, capital is wasted as producers try to protect themselves from the damaging impact of inflations and deflations, which ultimately weaken the entire pricing system. The upshot is that prices will eventually come down. But in the meantime, we’ll all be getting squeezed at the pumps. 

Dr. Jude Wanniski
19 June 2000

Reprint Permission courtesy of http://www.polyconomics.com
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Jude Wanniski, president of Polyconomics, Inc., Morristown, New Jersey, is one of the leading political economists in the United States. A prolific writer and profound thinker, it was Mr. Wanniski who, as Associate Editor of The Wall Street Journal from 1972 to 1978, repopularized the classical theories of supply-side economics. His book, The Way the World Works, published in 1978 to critical acclaim, and which brings a passion and eloquence to the supply-side model of political economy, became a foundation of the global economic transformation launched by the Administration of President Ronald Reagan.

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