Is Oil Overpriced at $105/Barrel?

The price of crude oil closed at $105 Thursday, a record new high. As the price of oil continues to climb, people are questioning how high it will continue to rise. Traders are already betting on it reaching $125 by December 2008, as evidenced by the recent options market activity.

While there are groups of economists and financial managers publicly stating that the price of oil is already too high, that may not be the situation.

Risks of Thinking Inside The Box

(i.e., only considering the price of oil in U.S. dollars)

Since February 2002, the U.S. dollar has declined 76% against the Euro. The dollar to Euro exchange rate on February 1, 2002 was $0.859 to 1 Euro. As of Wednesday, this exchange rate was $1.512 to 1 Euro. Given that oil is priced in dollars, the falling dollar is also a major factor to consider when determining if the price of oil is too high.

Source: LA Times

The price of oil has risen much less when considered in Euros rather than dollars. In February 2002, it was at $18.88 per barrel (or € 21.69, based on €1.149, 28-day average exchange rate). Converting the closing price of $105 to Euros equates to € 69.44, based on the conversion of $1.512 per €1. So the increase in U.S. dollars from $18.88 to $105 is a whopping 456% price increase in five years. However, when calculated in Euros, the price of oil rose by 220% during the same period. While this is also a large increase, it is much less than currently reported in the media.

So, it is only logical for the Saudi Oil Minister and other members of OPEC to consider moving away from the dollar peg and adding Euro pricing.

The Risk of Pricing Oil in Euros

If the dollar continues to fall in value versus major currencies such as Euro, Yen and Pound, it will have dire consequences for the U.S. economy. If OPEC begins pricing oil in Euros, we will see spikes in gas, oil distillate, and manufacturing prices in the U.S. Given that the U.S. economy is in a recession and may face slipping into a depression, this is a possibility that we should take into account. Should the U.S. slip into a depression, the Fed would have to continue lowering the Fed rate, perhaps down to 1% or even match Japan’s 0.5%. If that occurs, the falling value of the dollar against other currencies would accelerate.

The Risk of Assuming that the Dollar is Still a Global Standard

Not too long ago, the global currency was the British Pound. This Pound Sterling standard began to lose its luster shortly after World War II, beginning with the Bretton Woods system of monetary management. In the 1970s, the global currency began to drift toward the U.S. dollar. While we in the U.S. still believe that the U.S. dollar is the global standard, a recent study on the Euro versus the dollar by David Cobham of Heriot-Watt University, Edinburgh seems to indicate otherwise. In his draft report dated May 2007, Professor Cobham concludes

…more countries anchor consistently to the euro than to the dollar; this is not because more countries than expected anchor to the euro, but because less countries than expected anchor consistently to the dollar.

If Professor Cobham’s study is correct, then it is not too long before OPEC begins pricing oil in Euros.

The Long Term Risks of Rising Oil Prices

If the geo-political instability in oil producing regions and the war in Iraq continue, the potentiality of the price of oil will continue to increase. Additionally, this will have a direct affect on the prices of gasoline and oil distillate. It would not be long before the price of gas will reach and perhaps go above $4 per gallon by 4Q 2008 and even begin approaching $5 per gallon by early 2009. As trucks move the majority of raw and finished materials in the U.S., this will also cause inflationary pressures on the price of all products. In a word: stagflation. The repercussion of price inflation coupled with a weakening economy will lead to a vicious downward spiral culminating in a severe depression not seen since the Great Depression of 1930s.

Comments

[Manny Otero]

Thank you for this interesting and informative article regarding your perspective of the relationship between the increasing price of crude, and the subsequent decline of the dollar's value. While your analysis is offers on perspective, it fails to consider the inherent globalization of the world economy. That is to say, it is incorrect to consider the US economy isolated from the major world economies, which I believe we could classify as Europe, Brazil, India, China, Japan, and Russia (I would not lump them in with Europe, although socio-politically and geographically, they are). Should the US economy fall into continued recession or depression, world economies would also significant suffer, causing depreciation in their currencies. This creates a complex regulatory network, where economics forces will continue to create balance.

In short, the rising increase of oil, and the depreciation of the dollar, while causing short-term economic recession in the US, will serve as market forces to cool world economies. It has been demonstrated many times in history, that when this economic condition arises, it is those countries that increase productivity, primarily through innovation, that will pervail. I have no doubt that we continue to lead the world in innovation, and no country in history has had the ramp in productivity, normalized for GDP, that we have had.

So, while you can paint a fairly dark picture, and ultimately history my judge you to be correct, I respectfully disagree. Market forces, more than ever given our gloabalization are in effect, and will normalize the turbulence we're now experiencing. In practical terms, what I am saying, is that while oil surpasses $106/barrel, and the dollars hits all time lows against the Euro, those countries that use Euros will start to see their productivity decline, because they're so inherently tied to the US, and other markets. This decline will cause a rebound in the US dollar.

Believe in free market capitalism - it has worked, and continues to work.

-Manny Otero

[goatfarmer]

Charming and polite comment from Manny Otero!

[paultaut]

Gazprom has already announced that they will not accept dollars in 2009.

The Chinese currency has appreciated more that 10% against the dollar in the last year, it is anticipated to appreciate more than 10% this year.

The Yen has appreciated over 15% in the last 6 months.

I expect full scale intervention might stall its decline or maybe a war somwhere...but time is not on the side of the US dollar....just like it wasn't on the side of the British Pound when it was once the world's reserve currency.

[paultaut]

just read Manny O's response......

Europe does more business with the Middle East than it does with the US.

Japan does more business with China than with the US...

Times have changed. The US used to be 40% of the global economy...it is now approaching 20%....

What do we export Manny? Certainly not much in the way of Goods.

What does the rest of the world need that we have?

And when will tariffs start on what we do export as we deliberately devalue the Dollar.

[ElliotMiller]

Paultaut shows the basis for the decoupling of the Us from the global economy. The facts he recites also show the folly of attempting a reversion to protectionism and away from free trade.

[asd]

"and the war in Iraq continue, the potentiality of the price of oil will continue to increase."

Well, US intervention in Iraq is necessary for them to pump any substancial amount of oil at all.

[Vukephalos]

Manny has a charmingly naive take on market forces. Yes, they do ultimately work but not quite in the manner he perceives.

Market forces are now driving the dollar down to that level at which the U.S. is in balance with the rest of the world. Rigged GDP and productivity figures will not save the economy from serious decline, rather it is innovation and production of things the rest of the world really does need that will arrest the decline. That, and a good dose of diplomact in lieu of bombs should do the job.

[jt]

Vuke...very diplomatic description of Manny's little rose-colored glasses analysis. The most naive part of it is his last line:

"Believe in free market capitalism - it has worked, and continues to work."

Yes, I truly believe that had we had a free market, we wouldn't be having all these problems now...and free markets would be the only way out of it, though painfully (there's going to be pain anyway, but at least we'd be heading back toward healthy). But our markets haven't been free for a long time, and esp not the commodities markets. The gold and silver markets have been "managed" (that's that sugar-coated word for "manipulated"... GROSSLY for many years by the anti-gold cartel made up of the Western Bankers, and esp the Fed, their bullion/investment bank lackies, esp GoldmanSuchs and JPMorgain4Elites, and our own Treasury Dept. The Fed(eral Reserve Banks) have made and continue to make a fortune "loaning" non-existent money/FRNs to our Treasury and we keep paying interest on it...costs them nothing...makes them an otherworldly fortune. Gold and silver remain the world's premier currencies, despite the cartel's (and the establishment's that has benefitted from the limitless allowance given it by the Fed) having done its best to brainwash the people that gold is just some "barbarous relic" and to short the crap out of the PM mining shares (ala, TSX) to try to dissuade investors from pulling their monies out of the DOW and the DOG and Treasury bond(age)s and putting them into PMs and their equities. It also has prevented the investing public from seeing just how bad a shape the economy and the dollar are in...the price of gold and silver being one major signpost. (Imagine removing all the signs on the side of the road that a bridge is out up ahead...it creates what is called a "moral hazard.")

JPM in the meantime has had a nearly unfettered hand in shorting commodities out the wazoo (their derivative risk, mainly shorting, is in the $$$Trillions of dollars), and yet an exec order thru the US Atty Genl Negroponte has excused them from following SEC guidelines for disclosure using the excuse that they are operating in the interest of natl security (shows you just how deep the rabbit hole goes, ie, it is our own govt fixing the markets and betting against its own people).

It was JPM almost singlehandedly that drove the price of NG down a coupla years ago, then basically put Amaranth out of business by its shorting without compunction...my guess, and I'd put a million bucks on it, is that they don't fear having to cover, b/c they are covered, by our own govt...and then bought up Amaranth's way-losing positions for pennies on the dollar.

And anyone watching the DOW for the past several years...actually, since ~2002 has seen MULTIPLE, sometimes daily, Hail Mary's coming out of nowhere at end of day, et al, to prop it up on a down day...with NO good reason (oh, not that the mainstream media won't pull one out of their hindquarters...or maybe they just throw a dart at a board containing all "acceptable" reasons...acceptable to TPTB that run the media...the bankers and their lackies). This is the PPT (its important-sounding name is the President's Working Group on Financial Markets) doing their thing by buying up DOW futures thru offshore hedgies, thus preventing the other major economic/financial signpost for this country from showing us what major trouble we're in...the DOW.

And that doesn't speak about the bond market or the removal from public view in March, 2006 of M3 by the Fed, or the manipulated CPI numbers and other bullscheisse coming from the BLS (the Bureau of Lying Statistics) to keep the public misinformed and so unforewarned about the dangers. So anyway, to even suggest that we have "free markets" that will somehow "come thru" in the end is ludicrous. You wish!!! (and so do I)

No doubt the coming depression in the US will affect the rest of the world, but not as severely as it will affect us. The dollar has lost its position as premier currency...you just won't read about it anytime soon. But non-Western CBs, Sovereign Wealth Funds, BigMoney people around the globe are well into slowly converting their worthless dollars into other currencies, and even more into REAL goods, such as gold, silver, oil, gas, companies with rights to the above, etc. The dollar is done...though as I've said...don't expect to read anything about that in the mainstream media until maybe decades after the fact.

jt

[Mr. G]

Being the largest economy on the globe, 70% of GDP depends on the american consumer who is taking a hit due to bad bank and greedy lending practises in the secured and unsecured industry, and the banks recent practises spells their own demise as well. They are not lending! Since consumer recovery is the vital issue to USA recovery,and the banks play the central role, their slow demise puts the US on a road to depression.

[StateofConfusion]

While corporations have been exporting US jobs, inflation has been kept under control by the cheap labor in Mexico and China. Now that the Chinese are consuming more goods, energy and food, the demand has raised prices. We make less and get paid less while prices will increase. We must get a good government to change our direction. I think the only solution is a massive program to produce domestic alternative energy and rebuild infrastructure. This will be equivalent to the moon program or WWII and must include national pride in conservation to greatly reduce oil imports. Seven years have now been lost and if we wait any longer, we may not recover.

[iThinkBig]

The comment above says it all, but I don't expect this will occur until the election cycle of 2012. Many, many Americans are now liberal, demanding someone to bail them out after mismanaging their own money for at least a decade on easy credit. A Democrat will most likely win the WH and redistribute wealth to the least deserving in our system. I speculate by 2012 the U.S. will be in it's second year of depression and that we will elect good leadership. If not, I expect a Washington to be overrun by the masses and decent government forcibly restored. The mere fact we are all discussing depression is awful, however I will say back in July I was telling colleagues chances of recession in 2008 were 100% and I was scoffed at. Glad I use my own spreadsheets to crunch, non-skewed data. I worked my *ss off and still have a business.

[KenBenobi]

"those countries that use Euros will start to see their productivity decline, because they're so inherently tied to the US"...

That premise is unsupported in Manny's argument, especially given how much more relevant China, Russia and the EU's dealings with ME governments has become in this decade.

Decent commentary, but a flawed conclusion based on faulty assumptions and traditional thinking. We are no longer the center of the universe and if you haven't noticed, American Innovation is not 20% of what it used/needs to be.

[PeterSterling]

America can secure all the oil and gas it needs to eliminate expensive imports from the Arctic Ocean Commons. all it needs is the balls to back the US privateers who laid claim to the resources in 2006. A Manhattan scale drilling and development program could see 5 million barrels a day flowing south within 10-15 years. Virtually all the money would stay in America creating jobs etc. The solution is that simple.

[BlueSky&Sunshine]

The combined comments of Paultaut, S-O-Confusion (sounds pretty level headed to me) and iThinkBig tell the real tale. The US has become hopelessly addicted to crude oil and cheap foreign goods bought on easy foreign credit. We've nearly exhausted many of our own natural resources (Arctic Ocean? Get real P. Sterling!) while allowing our manufacturing sector to be outsouced to workers making one tenth of what we call a living wage. Now the party may well be over. The subprime mess (and subsequent fallout) is just the last act. What's really unfortunate is that many of our biggest problems could be solved with ridiculous ease; If every driver of a full sized sedan, pickup, or SUV traded down to the equivalent of Honda Civic and reduced their miles driven by, say, one third, their fuel consumption would be reduced nearly 70%. The other 30% is tougher, but commercially practical (e.g. plug-in hybrids) cars are on the near horizon that would reduce consumption half again - especially if people practice even basic conservation. There is no downside to this and no real long-term alternative. Yet it's treated like a 3rd rail by all of our so called leaders. Regarding our trade deficit: How much domestic economic activity would be required to extend the life of, reuse, or recycle every durable and most non-durable manufactured goods used in this country, especially including packaging? I suspect more than enough to return our labor force to full time, meaningful, long term employment while putting a huge dent in our balance of payments problems and our consumption of all the "hard commodities" that've recently rocketed into orbit. A transformation like this would take many years. We could've started many years ago. It would probably take less investment than our current trade deficit. And it requires no new geopolitical risk or gee whiz technology, just good, determined leadership. And yet here we are. Sliding slowly and not so gracefully into ruin - like the Roman Empire in 21st century fast-forward.

[JustAsking]

paultaut: where do these numbers for the size of the US vs ROW economy come from? I've heard all kinds of things, including that it has been 30% +/- 2% since 1969 (see paul.kedrosky.com/arch...)

I don't know what to believe, which is the problem of reading too many blogs - you can always find something to support what you already believe:)

[flaco]

This article is very naive. Do you really think the US government is simply going to allow other countries to stop selling and buying in US dollars? Saddam Hussein started selling oil in euros and look at what happened to him. Iran has now started discussing doing the same, and despite reports saying the contrary, Bush is telling America how much of a threat they are..

[nukldrager]

Let's put jt, and flaco on the ticket, at least a cabinet position. The powers that be are not going to let the consumer become unable to consume for too long.

[pockyclips2020]

Manny, your assumption that oil behaves as a free market
commodity is incorrect. Oil has been manipulated since the day
Col. Drake drilled the first well. Now, not only oil, the paper we print the money on, and even the gold supply is being spun to meet the needs of the elite.

As long as we keep printing money to finance the "war on terror",
the price of oil will keep going up. The next interest rate cut will see
$125/barrel oil not in 2009, but THIS spring. We were given the first warning in 1973, but failed to heed. In the 1980's, Reagan dismantled our attempts to rid ourselves of the demons. Now with every fill-up, we provide funding to the same folks that are killing our kids in SW Asia.

Our only hope is not to decrease our addiction to oil, but find another way to fuel our economy. As long as we stand pat,
OPEC, the Russians, and the Globalists will keep the price just
below the threshold of change. We will get to the point that
the Arabs and the Chinese will have to write off our debt,
our we will pay them with nukes.