Tuesday, July 15, 2008

Why Are Oil Prices So High? Gold Solves the Riddle

from Seeking Alpha:

As the price of a barrel of crude oil continues to rise past $140 a barrel, one begins to wonder, is the price of oil primarily rising due to the strong global demand for oil, or due to the U.S. dollar [USD] falling so much in value?

One way to solve this riddle is to travel back in time to the 20th Century when after World War II the USD was considered 'as good as gold' because the exchange rate between the USD and gold was fixed by U.S. federal law at 1 USD = 1/35th of an ounce of gold; that is, until President Richard M. Nixon shocked the world by unexpectedly yanking the USD off the gold standard on August 15, 1971. Or, travel even further back to a time centuries ago when men and women the world over used gold as a medium of exchange, a store of value, and a unit of account. Back then, prices of almost all goods and services were quoted in units of gold. Looking at the price of oil from this historical perspective, a new question arises: Would the price of crude oil be rising so much if the world were paying for a barrel of oil with ounces of gold instead of the currently 'goldless' USD?

Thankfully, we can use readily available historical data on gold, oil, and the U.S. dollar to answer that question. The key is to transform the data -- and our thinking -- such that a single ounce of gold becomes the currency (or, unit of exchange) that anyone could use to buy and sell a barrel of crude oil or to buy and sell the currently 'goldless' U.S. dollar. Applying this data transformation and then using 1991 as a normalized index point (January 1, 1991 = 100) for both oil and the USD, the logarithmic graph below uncovers a hidden truth: starting in late 2001 (around the time of the September 11 terrorist attacks on the U.S.) through today, anyone could use a single ounce of gold to buy an ever-increasing number of U.S. dollars (the red line), or anyone could use a single ounce of gold to buy an ever-decreasing number of barrels of crude oil (the blue line).

Normalized Index for Gold Ounce Price of Barrels of Oil and U.S. Dollars (January 1, 1991 = 100)

Graph © 2008 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Used with permission. Time period shown in diagram: 1/Jan/1991 - 14/Jul/2008.

Looking at the graph another way, the red line reveals that an American today is having to spend almost 2.7 times the number of U.S. dollars he had to spend back in 1991 to buy a single ounce of gold (July 14, 2008 = 268). This is confirmed by comparing the USD prices of one ounce of gold in 1991 and today: $362 and $971, respectively.

Similarly, the blue line reveals that anyone today using an ounce of gold as currency can only buy 40% as much crude oil per ounce of gold as he could in 1991 (July 14, 2008 = 40). In other words, anyone must now use 2.5 times as much gold as he could in 1991 to buy one barrel of oil. This is confirmed by comparing the gold ounce prices of one barrel of oil in 1991 and today: 0.06 ounces of gold per barrel and 0.15 ounces of gold per barrel, respectively.

So, a barrel of oil has increased in price by 150% in terms of gold ounces since 1991 and, at the same time, an ounce of gold has increased in price by 168% in terms of 'goldless' U.S. dollars. Thus, gold solves the riddle: the price of crude oil is high and rising primarily due to the 'goldless' USD losing its purchasing power, and secondarily due to the strong global demand for oil. That is why the same single barrel of oil that cost only $23 in January 1991 costs over $140 in July 2008.

In short, as the U.S. dollar in his pocket becomes increasingly worthless, the average American is being forced to cough up more 'goldless' U.S. dollars to convince a seller of a barrel of oil to make a fair trade. Who can blame the oil seller if she believes "fair" requires ever more increasingly worthless U.S. dollars to complete the sale of an increasingly demanded barrel of oil?

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