Angry Over Oil Price? Demand a Change in Fed Policy

The price of oil has shot up over $100 a barrel, and the price of gasoline is headed to $4 a gallon.

True to form, the call has gone out to “round up all the usual suspects.” Channeling the orders of Captain Renault of Casablanca, the Congress and the press go after speculators, “greedy” oil companies and Arab sheiks, profligate American consumers, and the ever-handy Chinese.

Why is the price of oil going up – driving up the cost of gasoline, heating oil and many other products you rely on every day?

The immediate cause is fear of disruptions in the supply of oil due to unrest in the Middle East. The scramble to secure oil supplies now and into the future has contributed to the sharp increase in the price of oil on both the spot market and for future delivery.

But the true perpetrator of higher oil prices, the Federal Reserve, stands right in front of us, the smoking gun its easy money policies. As I wrote last November, what is making today’s higher oil and gasoline prices inevitable is the debasement of the dollar.

We can show the truth of this accusation by examining what would have happened to the price of oil had the US government kept its promise that the dollar was worth 1/35th of an ounce of gold. This guarantee was made by the Gold Reserve Act of 1934, and reaffirmed under the 1944 Bretton Woods agreement for the post World War II international monetary system. President Richard Nixon broke this promise in 1971 by suspending gold convertibility. Ever since, the government has eschewed any guarantee for the dollar’s value.

What would the price of oil be today if the dollar was still worth 1/35th of an ounce of gold?

Approximately $2.60 a barrel – or 10% less than oil’s average price of the 1960s and only 20 cents higher than it was in 1999. This answer shows that today’s high oil prices have been caused by a fall in the value of the dollar.

Here is additional evidence. It may not seem possible now, but the 1980s and 1990s were two decades in which the price of oil was in a general downtrend. Under the strong dollar policies of the Reagan Administration and Paul Volker’s leadership at the Federal Reserve, the price of oil fell from an average of $38 in 1980 to $20 in 1989.

The price of oil did jump during the first Gulf War, averaging $24 a barrel in 1990. But by 1992, it had fallen back to $21. And under the strong dollar policies of the Clinton Administration and the then steady hand of the Greenspan Fed, oil prices remained in a narrow range, ending the decade in 1999 at $19 a barrel. Over these same two decades, the dollar price of gold also fell by roughly 50%, to $279 in 1999 from $604 in 1980. This experience shows that when the value of the dollar went up, the price of oil went down.

However, the administrations of both Presidents George W. Bush and Barack Obama have pursued weak dollar policies in their misguided attempt to improve the competitiveness of US companies and to stimulate the economy. As the value of the dollar has gone down, the price of oil has gone up. Since 1999, the five-fold increase in the number of dollars it takes to buy a barrel of oil has simply caught up to the five-fold increase in the number of dollars it takes to buy an ounce of gold. In other words, the entire increase in the price of oil since 1999 can be attributed to the debasement of the dollar.

Over the short term, our pay does not keep up with a sudden jump in oil prices. The Fed’s easy money policies have cut the real wages of American workers and reduced the value of all or our savings and investments. Higher energy prices and the loss of real income and wealth triggers a costly adjustment process. More money spent on gasoline and energy means there are fewer dollars to spend on everything else. Jobs are lost, fewer jobs are created, economic growth slows. As time passes, other prices – including wages – rise as they adjust to the now lower value of the dollar, a process which is recorded as a general increase in the rate of inflation. (See “Higher Inflation Is On The Way.”)

None of this should be confused with an energy crisis. As Nansen Saleri, the CEO of Quantum Reserve Impact in Houston and former head of reservoir management for Saudi Aramco, reported in his article in The Wall Street Journal, existing oil capacity exceeds current demand by between 3 million and 5 million barrels of oil a day. And, plenty of new energy supplies are on the way. New drilling technologies have led in recent years to a modest increase in US oil production, and over the past two decades, to a six-fold increase in US conventional natural gas production.

In addition, according to the US Energy Information Agency, the US has reduced its energy consumption per unit of GDP by nearly 50% since 1980 and 20% since 1999. This trend is likely to continue in the decades ahead.

Demonizing speculators, oil companies, Arab sheiks, American consumers, or excusing higher oil prices by blaming strong growth in China and other emerging markets is classic misdirection. The result is to keep the federal government and the Federal Reserve from being held accountable for policies that drive down the value of the paper dollar.

So what should be done?

To stabilize the price of oil and free the American people from the specter of energy crises, do not round up the usual suspects. Instead, hold the Fed and the Obama Administration accountable for their easy money and weak dollar policies. Demand an immediate arrest to the debasement of the dollar and in due course a renewal of the guarantee of the dollar’s value in terms of gold.


Charles Kadlec
for The Daily Reckoning

The Daily Reckoning