Should Oil Be Trading at $60 or $150?

Can the price of oil be blamed on commodities investors and futures traders artificially driving up values? While the price of crude oil was surging past $100 a barrel last week, Philip K. Verleger, Jr. was busily penning his latest letter, "Notes at the Margin," to the clients of PKVerleger LLC. Clarence Cazalot Jr., CEO of Marathon Oil, was in Verleger's lede and on his mind.

Cazalot has firmly planted the blame for oil prices on the heads of futures traders and "the premium as to perceived instability in the world. If we bought and sold crude oil purely on principles of supply and demand, there's no question in my mind the price would be lower than where it is today."

This did not set well with Verleger, a staff economist at the Council of Economic Advisers (1976-77); director of the Office of Domestic Energy Policy at the U.S. Treasury (1977-79); and senior research scholar and lecturer at the School of Organization and Management at Yale (1979-82). A prolific writer, Verleger has also researched and authored several books about the energy industry, including "Adjusting to Volatile Energy Prices" (Ballinger Publishing, 1993) and "Oil Markets in Turmoil" (Ballinger Publishing, 1982).

"There are at least two fundamental reasons that explain the price rise: fear of inflation and the growing squeeze on sweet crude supplies," wrote Verleger. "The more important factor is the fear."

Verleger, imminently at home with discussions of policy, also sees a direct line from crude prices to the Federal Reserve.

Verleger once declared current Federal Reserve Chairman Ben Bernanke "a brilliant academic" for a paper he co-authored with Mark Gertler and Mark Watson, titled "Systematic Monetary Policy and the Effects of Oil Price Shocks." Examining the 1973 and 1979-1980 recessions, the authors concluded that none of it was necessary had the "central bank kept inflation in check."

Now that Bernanke is in charge of the Federal Reserve, has he stuck by his pledge?

Verleger cites a recent speech by Federal Reserve Board member Frederic S. Mishkin, also a monetary theorist, where he says: "The science of monetary policy has also emphasized the importance of establishing the central bank's strong and credible commitment to keeping inflation low and stable over the long run because that commitment helps to stabilize inflation expectations; in turn, stable expectations aid the functioning of the economy and the efficacy of policy."

Sounds good, but how does that gel with the Fed's interest rate cuts of 225 basis points over the last six months?

"The ‘monetary scientists' have allowed inflation to get out of hand," Verleger declares. Central bankers, he contends, have done nothing to curtail the price rise of crude oil and retail petroleum products from 1999 to 2008. Instead, they saw price increases as "transitory problems."

Verleger quotes Bernanke, in 2004, telling Georgia college students that the rise from $33 to $55 per barrel during the first nine months of that year was speculation and transitory, with no long-term effects on inflation.

Catch-22

But in fairness, Verleger admits that Bernanke had only a Hobson's choice recently when he moved to lower interest rates aggressively: raise interest rates to try to control inflation "and risk collapsing the financial system" or forego the war on inflation by reducing interest rates in order to avoid financial collapse. But at what cost...?

Verleger argues that the rate reductions actually reduced confidence, and hints that Bernanke may be missing a second source of commodities inflation.

"[T]he price of oil," Verleger says, "is being pushed to unreasonable levels because investors and traders have lost confidence in the government's ability to control inflation."

Oil prices will continue to rise, insists Verleger, who compares the rise in oil to the accompanying rise in silver prices during the 1980s oil crisis, which is mirrored by the rush to commodities today. CalPERS, the California retirement fund for state employees, is increasing its investment in commodities, notes Verleger, from $450 million to $7.2 billion. This will mean an additional 36,000 crude futures to the fund's portfolio. The push on these futures is also reminiscent of silver, he says.

Silver's rise was ended by government intervention, when Fed chairman Paul Volker asked banks to stop lending to investors buying commodities. "I suspect the continued rise in oil prices will be broken only when the Federal Reserve, CFTC, NYMEX and ICE take similar actions. To be specific, I expect to see prices fall when the central bank orders banks not to lend to hedge funds to purchase commodities."

Not a mainstream view, to be sure, but one that you're starting to hear occasionally from the sidelines.

Verleger figures among the tumultuous market's winners and losers will be the refineries that will lose revenue due to operations problems and the dent ethanol will put in refinery demand for gasoline production, which he expects to carve 9 percent from their balance sheets. While gasoline spreads are collapsing, he expects distillate margins to keep widening. There is a shortage of low-sulfur diesel, and demand is rising. European refiners are well-positioned, as opposed to U.S. refiners, to make out on this one.

Meanwhile, Verleger won't be surprised if WTI crude oil goes to $150 a barrel and the euro doubles in value against the U.S. dollar.

We'll see how it turns out....

Comments

[AmesTiedeman]

The simple fact that it is not trading at $60.00 equates to the simple fact that it should not be trading at $60.00. As for $150.00. Of course Oil will see $150.00. It is not if, but when. Three years, Five years, One year..

[User 163933]

In the simplest case, a futures market should have little or no influence on "spot" (real-world) commodity prices, because no actual orange juice or pork bellies change hands when contracts are traded.

During the gold and silver runup of the 1980s, both large investors and the public began to hoard those metals. People's home safes and bank vaults filled up with gold bars, while individuals bought and held bags of silver quarters. Inevitably the result was a drastic increase in prices.

It's true that some unknown amount of hoarding of refined products is surely taking place, and of course such behavior could very well be influenced by the price of futures contracts, but overall I have trouble believing that there is sufficient hoarding to cause such price increases. Building inventories is of course another matter, and could certainly cause significant price increases if every country does it at once. Once inventory growth is factored in, it should be possible to find out how much of the increase in crude prices is due to an imbalance of production rates and consumption rates. I'm not saying it's easy to gather all the necessary data, but at this point, I think we need to stop running on conjectures such as "blame the futures traders" -- !

[blah-blah]

Excellent article - I was wondering what killed gold in the 80s

It'll be fun to watch it happen again now that all commodities are trying to be gold.

[NormanLepoff, M.D.]

Good article and good comments.

[ChristopherDeal]

I have decided to believe that the Fed is deliberately causing inflation. Who benefits? Debtors. Who are the debtors? The US treasury and people holding mortgages. The Chinese are holding over one trillion dollars of our notes and we will pay them back with dollars worth much less. How much less? It'll be fun to watch and see.
The home buyers mortgages will also get easier on their budget as wages rise to compensate for inflation. A couple three years from now, after the ARMs have been shook out, the price of homes should stabilize and even start rising...at the inflation rate, which could be between 10 to 15%. (numbers pulled outta my ear).
So, deliberate inflation helps the housing crisis and reduces the value of the nations debt. We did it to the Europeans and Japanese in the '70s and we're doing it to the world again today.
The wonders of a fiat currency.
We should be ashamed of the Fed, but hey, what are we gonna do about it? Let's make some money. I'm heavily into DGP.

[Hankhawk]

Since necessity is the mother of inventions, I hope oil goes
to $150 bl. this year. We've paid less than $2.00 for gasoline for many
years while most of the industrialized world was paying $4-$5.00
a gal. The USA got lazy because the supply was too easy to get .
Now, if we have to pay $4-$5 a gal, we'll come up with some wonderful alternatives and improvements -- not only for ourselves, but to benefit the world. If this is the kind of "kick-in-the-butt... we need -- so be it. Let's get moving.

[briskforme]

All I know is the further the oil is driven the more money the rich will have and the poor will suffer. The rich includes government. Lets all stop driving here in north america for 1 month and see what happens.

[alexx]

Good article, but it like many others miss a key point.
If the current Congress leadership demands an immediate inquiry into the negligence and irresponsibility of our own Congress-empowered CFTC, they will find out that it has reigned over the worst commodities bubble in our history and they probably are guilty of criminal negligence in not enforcing the laws that were put in their hands. All that CFTC had to do is to intervene in the futures markets, as the eyepopping leverage has attracted thousands of new players 4-5 years ago, led by the unregulated and unreporting hedge funds, and by mandating 50% and 100% margin requirements they could have burst this bubble in its infancy.(as they were doing in the previous 25 years to sugar, copper, coffee, pork bellies,and even silver in the Hunts 1980 fiasco) But they did NOTHING in the face of doubling,tripling ang even quadrupling of oil futures, nat gas, corn, wheat, everything. Isn't it idiotic that as we all witness the crash-deleveraging of our financial derivatives in the financial markets, one can still bet with impunity in the 16 to 1, 30 to 1 leverage in the futures markets? This, shall we call it an out of control casino, is still benefiting a few at the expense of all of us.Let us all call for an immediate ban on leveraged futures trading, at least for 30-60 days, and we'll all see if there was really any truth to the "demand" for commodities when all players have to put up their cash to play.In the previous 25 years of intervention in unruly markets, NO SPECULATORS stayed in the game when they had been requested to use their money for the game. This game has got to be stopped before it ruins the modrern world as we know it.

[JamesSeaberg]

The blogger, Christopher Deal got it right. In order to understand the system, one should read the excellent book of Edward Griffin: The Creature from Jekyll Island. Also the various good articles from mises.org are very illuminating. Under a central-bank-system prices rise always. It is the pupose of a central bank to make sure that nobody escapes total confiscation. That is what we see. Enjoy it.

[MrLagom]

SAUVE QUI PEUT!

[AmesTiedeman]

Oil might test 75, but not 60. I see oil at 150 in 5 years. Demand is there, supply is not.

[Spiv]

The answer to $150 oil is:

Williston Basin and the Bakken deposit.

41 degree API gravity crude, possible yield in excess of 500 billion barrells. Enough crude to make the U.S. import-free for 40 years!!!