April 08, 2005,
Goldman Sachs analyst Arjun Murti surprised the markets last Thursday with his prediction that global demand would cause the oil price to eventually reach $105 a barrel. That’s a shocking number, of course, but it’s thankfully one that is based on a faulty analysis. Yes, increased global demand has a lot to do with the high oil price today, but so does the dollar.
When the late Robert Bartley wrote about the oil shocks of the 1970s in The Seven Fat Years, he placed quotes around the word “shocks.” This was instructive. Bartley knew the real story behind expensive oil it had everything to do with the weak dollar that resulted from the Nixon administration’s disastrous 1971 decision to leave the gold standard.
Though the Saudis later ceased oil sales to the U.S. in response to our Middle East policies, we were still the recipients of Saudi oil as we bought Saudi oil from other places. Oil is a fungible commodity, and so long as we are buyers, there will be sellers. Sellers were as plentiful then as they always are and the Saudi oil “embargo” was largely symbolic.
What wasn’t symbolic was the value of the dollar and its fall on world markets. Since oil is priced in dollars, it was only natural that the oil price rose substantially in the 1970s. Early in that decade, oil “shocks” were a U.S. phenomenon related to the Federal Reserve’s failure to maintain dollar stability, and a world phenomenon to the extent that other currencies followed the dollar’s inflationary descent.
As for the 1975-79 oil “shock,” the U.S. was at that time importing 35 percent of its oil, while Japan and Germany were importing roughly 90 percent of their oil. The latter two countries had a far greater reliance on “imported” oil, but the price of oil in dollar terms rose 43 percent compared to only 1 percent in Germany and 7 percent in Japan. In Switzerland, the price of oil actually fell 7 percent in the 1975-79 period as a result of the Swiss franc’s rising value.
Similar to today’s $105-a-barrel projections, there were those who predicted a barrel price of $100 as the 1980s began. This was entirely possible given the Carter Fed’s mismanagement of the dollar. Ronald Reagan’s election ultimately led to a change in dollar policy, and with that change came a fall in the price of oil.
Such are the ups and downs that come along with a floating currency. But things need not be so unpredictable. Just look back to the period when the dollar was tied to gold.
Economist Judy Shelton wrote in Money Meltdown that from 1947 to 1967, the yearly real gross domestic product of Britain, France, Germany, and Japan averaged 6.4 percent. This occurred alongside U.S. growth of 3.6 percent. Despite the impressive growth of the world’s largest economies in a world far more reliant on oil, the oil price pretty much stayed flat at $2.50 a barrel throughout this booming economic era.
The reason why oil producers were far more able to meet economic growth with supply between 1947 and 1967 has to do with the U.S. monetary regime at the time and the fact that the dollar was fixed at $35 an ounce of gold due to the Bretton Woods agreement.
Producers could drill for oil during the Bretton Woods era highly confident that they would receive $2.50 a barrel. As evidenced by the fluctuating oil price since 1971, the floating dollar has introduced major instability that made occasional shortages and gluts inevitable. Oil hit a low of $10 a barrel in 1998, and that low price goes far in explaining why today’s price has risen across all currencies.
Just as it took 20 years for traders of Treasurys to forget the inflationary 1970s and bid yields down to recent lows, oil producers will logically be reluctant to bring oil out of the ground given memories of $10 oil. The dollar weakened in recent years, but if the Fed reverses course and strengthens the dollar, nominal returns on oil investments could easily turn negative.
To be sure, today’s Fed is no Carter Fed, so $105 a barrel is a silly prediction. But the Fed can do better. What is needed is a commitment on the part of the Greenspan Fed to dollar stability, ideally in terms of gold. A message like this would give oil producers the confidence to make up for any shortfalls with new supply. As economists Peter Huber and Mark Mills note in their latest book, The Bottomless Well, we’re not running out of oil.
On the other hand, oil producers are arguably running out of patience with a floating unit of account that makes it very difficult for them to commit investment capital to the discovery of a commodity that is extraordinarily volatile in dollar terms. Dollar price stability will remove major uncertainty from oil exploration and will insure that we have the necessary supply at stable prices as countries hopefully continue to liberalize their economies, and in doing so, continue to grow.
John Tamny is a writer in Washington, D.C. He can be contacted at firstname.lastname@example.org.