It’s difficult to overstate just how panicked the world was over oil prices a decade ago — stratospherically high oil prices. We were, most policy makers and economists believed, in an energy crisis — the result of a desperate shortage of petroleum that could only be solved with cellulosic ethanol and windmills. During this “energy crisis” of 2006, we wrote the following Wall Street Journal commentary, hoping to calm fears of peak oil and other such nonsense that often accompanies big price swings. We said oil prices likely would recede. We said vast stores of oil, especially in shale, were about to be found and extracted. We said alternative energy schemes in part justified by high oil prices were a bad idea. We also said a big financial disruption was likely. The macro environment is very different today — prices are low instead of high; the dollar strong instead of weak. In fact, we’ve been telling clients for the last year that today’s environment looks much like the late 1990s: a strong dollar, plummeting energy and commodity prices, soaring prices for abstract technology firms like Internets and bio-techs, and trouble in emerging markets. We reprint this column as a reminder of the economic fundamentals…and energy’s abundance.
The Elephant in the Barrel
The Wall Street Journal — August 12, 2006
by Bret Swanson
Nigerian pipeline explosions, Chinese demand, Arab angst, Venezuelan volatility, peak oil and a Putin premium: These are the usual explanations for high petroleum prices. But our discussion of the “energy crisis” has ignored the elephant in the barrel — monetary policy. Today, high oil prices are the backdrop for Middle Eastern chaos and calls for bad energy policy. It was much the same in the 1970s, when high prices yielded similar violence against our fellow man and against economics. This is no coincidence. A weak dollar is the culprit, now as then.
When the Yom Kippur war was launched in October 1973, the price of oil had been rising for two years. For decades, oil’s price had been remarkably stable, like the prices of most other goods. But in 1971 Richard Nixon broke the dollar’s links both to gold and to key foreign currencies. Bretton Woods — and the dollar — collapsed, and a decade-long inflation began.
By July 1973, gold had deviated from its long-time price of $35 per ounce and soared to $120. Oil also responded quickly to dollar weakness and doubled in price by the early autumn. The Mideast nations complained that the Western oil companies were accumulating massive “windfall profits.” Having negotiated agreements in the previous environment of price stability, the Arabs and Persians were stuck with much lower prices and royalty payments. You know the rest of the decade’s news: embargoes, gas lines, inflation, wage and price controls, hostages.
Today, commodity prices across the board, from coffee to carbon fiber, remain near 25-year highs. High oil prices are not a unique phenomenon, but just another commodity whose price is determined primarily by the value of the dollar. Expensive oil isn’t exclusively a monetary event, of course: Risk and demand matter, too. But in comparing oil to other commodities, especially gold, we find that elevated risk and demand explains only $10-$15 of the higher oil price; $30 of the price is explained by a weak, inflationary dollar. The entity most responsible for expensive oil is thus the Fed.
