Peak Oil and Inflation

Oil has become the “anti-dollar” of modern times. Oil is now serving as the source of global monetary discipline that gold used to perform.

Oil is the energy life-blood of all modern economies. So when a nation debauches its currency, the oil markets react instantly. And oil will not accept monetary malpractice, certainly not by the U.S. Federal Reserve. If traders perceive that the dollar is declining, this perception lights the fuse for oil prices to rise.

There is an old saying that “You can’t fight the Fed.” But oil is fighting the Fed. In fact, oil is scoring a knockout, like Muhammad Ali over Sonny Liston. Oil is floating like a butterfly and stinging like a bee — landing body blows and pinning the Fed against the ropes.

The Fed can no longer cheat with the money supply and get away with it. There is a new gold standard and it’s called “oil.” This may not be a monetary “fact” that central bankers would acknowledge publicly. But it is a monetary fact of life out in the trading pits.

Even the President himself is powerless to alter this new fact of life. He cannot simply fortify the dollar’s supremacy by seizing the world’s oil at $20.67 a barrel, like Franklin Roosevelt seized America’s privately held gold for $20.67 an ounce in 1933. And even if the President could confiscate the world’s oil at below-market prices, he might not understand how such a confiscation would influence the dollar’s value.

The “oil connection” to monetary policy is a new and poorly understood development. It’s not what people expect. It’s not how we all grew up. It sure did not used to be this way.

For the past 149 years, it has been a fairly safe bet that the world’s oil supply would grow. The only truly difficult period for oil was between 1979 and 1981, when the Iranian oil industry collapsed in the wake of revolution. The world supply-chain lost nearly five million barrels per day of output. And that loss helped produce the worst recession in the U.S. since the 1930s.

But even back in the early 1980s, new oil sources were coming online. Everybody could see it. The fields of Alaska, the North Sea, Mexico, Angola and other places were just kicking into gear. So the price of oil could not go “too high” because there was a clear indication in the marketplace that there would be more oil coming down the pipes.

And that’s exactly what happened. By the mid-1980s, oil was selling for less than $15 per barrel. Cheap energy made a lot of things look easy, from growing the economy to winning the Cold War.

There was a dark side to cheap oil, however. It produced and nurtured the illusion that oil would be cheap forever…or at least for a very long time. But looking ahead from today, it is crystal clear that it will be more difficult to grow the worldwide oil supply than in the past. We may be at Peak Oil right now, but we won’t know that for a while.

Oil-producing areas like Alaska, the North Sea and Mexico, are in decline. Meanwhile, as worldwide oil demand grows quickly, oil output is at a measurable plateau. There is almost no “spare” capacity anywhere outside of Saudi Arabia, and the Saudi margin is smaller than most people think. At the same time, net oil exports are decreasing from most oil-producing nations. Internal demand is rising in almost all oil-producing states. So there is simply less oil to go around. And unlike in the early 1980s, there’s no relief in sight.

Oil supplies are severely constrained. Dollar supplies aren’t. Perhaps these related facts are what inspired Alexey Miller, the CEO of Russia’s oil giant, Gazprom to predict that oil would rise to $250 a barrel in “the foreseeable future.” The Fed can “talk” a strong dollar all it wants, but as long as the supply of dollars and dollar-denominated credit continues to grow, the oil price will continue to climb.

In the era of Bretton Woods, the global monetary system followed the golden rule: “He who has the gold makes the rules.” But today, the “rule of crude” dominates. Thus we are left to ask, what is the meaning of crude oil at $137? It means that the reign of the dollar is coming to a close. The dollar has reached the end of its post-Second World War period of dominance as the world’s reserve currency.

That’s why today’s oil buyers, like the late French President Charles de Gaulle, are so eager to exchange their dollars for a tangible asset. De Gaulle shipped France’s dollar reserves across the Atlantic in exchange for gold bars from the vaults of Fort Knox. Today oil traders are shipping their excess dollars to the New York Mercantile Exchange in exchange for barrels of oil. The motives are identical. Only the underlying monetary asset has changed.

So what of the U.S. dollar? Well, a man named Lazarus once rose from his deathbed. But Lazarus had some help. Could the dollar be as fortunate as Lazarus? These words come to mind, from the Book of Luke at 17:37: “Wheresoever the body is, thither will the eagles be gathered together.”

Until we meet again…
Byron W. King
June 16, 2008

P.S.: The economic principles behind what you’ve just read are really quite simple. Oil is gaining in value while the dollar is losing, and it all comes down to one word: scarcity. Oil is becoming scarce while the dollar is increasingly more abundant. Savvy investors realize this when investing in commodity markets, especially the energy sector. And that’s the main focus behind my investment research service, Energy & Scarcity Investor.