What’s Driving Oil Higher? It’s the Dollar, Stupid!

In this article, I will debunk the many articles that attribute inflation to rising prices and rising oil prices to nefarious OPEC nations that squeeze production and gouge Western nations. With the use of four charts, I can explain most succinctly what is the predominant factor in contributing to rising oil prices.

Just as inflation causes rising prices, and not the other way around, the falling dollar is the greatest single determinant of soaring oil prices, not speculators and not a shortage of supply. Sure, these other factors contribute to rising oil prices and shortage of supplies will certainly drive oil prices even higher in the future, but they are not THE main contributor today despite all the articles to the contrary. That honor goes to the falling dollar. To understand, take a look at the four charts below.

I have plotted the USO [AMEX], the United States Oil Fund, LP against gold, silver, the euro and the U.S. dollar for the last 3 years. The United States Oil Fund, LP (USO) invests in futures contracts for light, sweet crude oil and other types of crude oil, heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the New York Mercantile Exchange [NYMEX], International Currency Exchange [ICE] Futures or other United States and foreign exchanges, so generally it acts as a very good proxy for the price of crude oil (and gas).

If we look at the USO plotted against fiat currencies, it indeed appears that the price of oil is soaring. The USO has soared about 52% against the Euro in the last 3 years. On any terms, this is quite a hefty rise, but even this hefty increase pales in comparison when we observe the 3-year chart of the USO priced in U.S. dollars.

In U.S. dollars, the USO has soared by more than twice the rate it has against the Euro at 115%. However, because both the Euro and the Dollar are fiat currencies backed by nothing but the full faith and credit of governments, they theoretically can both be debased into worthlessness.

So now let’s price the USO in gold and silver for the past three years. When we do so, a markedly different picture emerges. The USO, over three years, despite having soared by 52% and 115% when respectively priced in Euros and Dollars, has incredibly dropped in value by 11.5% over the same time period when it is priced in gold. This means that oil would actually be cheaper than its price from 3 years ago were we to price its cost in ounces of gold. In other words, if the dollar was on a true gold standard today, nobody would be talking about soaring oil prices.

And what about when priced in terms of silver? If we price the USO in ounces of silver, we see from the below chart that the price of the USO has plunged a monumental 25% in price over the last 3 years.

So what does this tell us? In very simple terms, when goods are priced in stable currencies, their prices remain much more stable as well. When goods are priced in unstable, highly inflated currencies, then their prices soar primarily due to the significant debasement of the currency they are priced in. Furthermore, as I explained in this previous article, the debasement of currency often gives rise to an illusion of wealth creation while in reality, it actually destroys real wealth.

Though many others wish to confuse you with complex algorithms that include 50 different variables that determine why prices rise, in our current environment, dollar debasement is the top contributor. Yes, I do understand that it REALLY is not that simple, as the dollar has risen in recent weeks and so has oil, but you get my point, right? I’m not here to discuss other factors such as the spreads between futures and spot prices which move markets and what not, but just to discuss a very important point that I never see discussed in the mainstream media.

So if oil had been priced in Euros for the past 3 years, analysts would only now begin to start discussing rising oil prices. And if the world had been forced to keep large reserves of silver and gold for the past 3 years to pay for their oil, well, the only discussion that would be happening today would be within the meeting rooms of OPEC as they tried to figure out how to increase diminishing profit margins from falling oil prices.

Of course, one could argue that were oil priced in gold from 1980 to 2001, oil would have soared in price as gold spent 21 years in a bear market during those years. However, were the U.S. dollar backed by a true gold standard during these years, the price of gold would not have plummeted either (this analysis is much too complex for the scope of this short article). So when people say that oil is heading towards $150 to $200 a barrel, this prediction, though they will never admit it, is primarily based upon the untenable situation of the dollar, not the dwindling supply of oil as they state.

In terms of gold bullion, the price of oil will most likely only get cheaper or remain stable in the next few years. And due to continuing debasement of the dollar, we are highly unlikely to see oil prices retreat past $80 a barrel anytime in the foreseeable future.

I have always found many stories reported in the media to be humorous. For example, this past month, recent IMF officials stated that rising prices of food and oil are creating raging inflation rates worldwide that are quite worrisome. This is comparable to blaming a destroyed orange crop in Florida for creating frigid temperatures instead of correctly attributing the frigid temperatures to the destruction of the orange crop.

Yesterday, a news article out of Washington stated the following: “US President George W Bush will discuss rising oil prices and subsequent effects on global economies with Saudi Arabia’s King Abdullah later this week.” The report further stated that “A White House spokeswoman also said that Bush would raise the issue of how high oil prices are draining the world economy.” While the debasement of the dollar is not the only contributing factor to rising oil prices, of all the factors, including dwindling supply, it is the largest singular contributor.

So again to use my analogy of the orange crops, singling out supply and production rates as being the most problematic factors in rising oil prices would be similar to discovering that 5% of all oranges destroyed by severe weather were also infested by bugs and then calling on a pesticide manufacturer to develop better pesticides as the solution. Of course, the best pesticides in the world still wouldn’t have saved the other 95% of oranges from being destroyed. In conclusion all the negotiation in the world won’t stop rising oil prices. Only a strong currency will stabilize prices and effectively moderate rates of inflation.

Comments

[Dan Walker]

"Yes, I do understand that it REALLY is not that simple, as the dollar has risen in recent weeks and so has oil, but you get my point, right?"

No I do not. Go back and look at the charts you posted above. Markets do not go straight up exponentially (as every one of the charts above show) under normal circumstances. Go back and read "Extraordinary popular delusions and the madness of crowds". I smell tulips. There weren't any hotshots wanting "to be the first one to buy a contract at $127 as there was at $100 today, were there? This may not top out until the end of the month but if you look at the charts, the brazen are becoming a bit more cautious at the highs. When even the bulls start becoming more skittish at "Going where no man has gone before" it is because the guys in the pits are acutely aware that there is almost no one left to buy. Wired.com featured an article Tuesday saying "oil would just keep going up" Since when did they know energy futures from ESD?

[JREwing]

To say, that the rise in oil prices is purely a reaction to the falling dollar is simplistic and it's really getting old.

The most recent records in oil were not accompanied by new record lows of the dollar.

If anything it is much more likely, that the opposite is true. High oil prices cause the trade gap to widen and then weaken the dollar.

The EURO is a bubble. Some one should tell the FX market, that they have lots of private and public deficits and they have a negative trade balance, too. And they import virtually all their oil, since North Sea oil is mostly british and norwegian.

P.S. I really don't get the author's thoughts on inflation. I always thought, that a rise in prices SHOWS inflation and not that inflation CAUSES a rise in prices.

[liorio1]

Its not the inflation, its the fiat currency as you point out. I agree, there are of course many factors that impact pricing, but to ignore the dollar??? Raise interest rates and lets see what happens.

[JREwing]

If interest rates were impacting exchange rates, the dollar would have outperformed the Euro until the Fed started to cut.

[Lester]

Why the confusion? Ever higher money-printing WILL result in ever higher prices for anything in demand. Put an icecream addict in charge of the money-machine and icecream will go to the moon too. Then everything else needed to make icecream will follow, milk, sugar, eggs, i.e. other commodities, even refrigerators and power.
Once the wave of demand has swept the whole economy, the media will most likely to blame the commodity producers for high prices, reduced living standards, i.e. INFLATION! Can it get any simpler?

[Ivan theCredible]

> ... but just to discuss a very important point that I never see discussed in the mainstream media.

You should listen to Peter Schiff. He is on CNBC and Fox a lot and makes exactly the same point about the debasement of the dollar, though admittedly he is often in a minority of one and is bashed by almost everyone else.

[Norm theFed-up]

We can keep taking this argument backwards in time as to the causes of oil reaching new highs to the American Revolution if we like. If it were strictly based on supply and demand, prices would be lower. There's plenty of oil and a long way until we've peaked. I've watched the price of oil change as much as $4 a barrel in minutes over the last few months based on nothing more than conjecture and rumors. The supply and demand was consistant as was the value of the dollar for those few minutes. Nothing had changed other than the attitudes, fear, and downright panic of the speculators who are actually controlling this market. It's not the Arabs....by the way....Canada is now our largest single supplier of crude....it's not the oil companies, it's greed. Put yet another blip like the "Nigerian rebels have blown up another oil pipeline which will result in the loss of 50,000 barrels a day..." and the price will go up yet again. In the mind of most of the morons on the street, that's a lot of oil and significant. In light of the 85,000,000 barrels a day that the world uses, that's the equivalent of an expensive celebratory dinner for four after you've just hit the lottery for a million bucks. The proverbial spit in the ocean. But it will impact everyone's pocketbook. And again, nothing significant has taken place to cause the change in price except panic. Good luck and enjoy the ride. Wanna save money on oil? DRIVE LESS!

[CentsLess]

I don't know where the author of this article lives but where I reside gasoline increased 21 cents or 5.7% overnight ($3.68 to $3.89). Did the dollar lose a comparable amount overnight? I think not! The devalued dollar is just another grasp at straws in an attempt to explain away higher prices. Add it to the list that began with greedy Arabs (OPEC), naughty Persians, Hurricane Katrina, refinery explosions, violence in Venezuela and Nigeria, gluttonous China, the former USSR, etc, archaic government policies. What next …Sunspots!! Somewhere buried in all the BS and rhetoric is the Truth. Maybe we’ll find out at the end of the quarter when the oil companies announce their most current results.

[WayneS]

Oil companies don't set the price of gasoline. Walmart probably has more gas stations than all of the oil companies combined. I think Exxon owns 700 gas stations worldwide. Gasoline has gone up 37%, crude 100%. Below is a quote about the major refiners in the U.S.

"Tesoro, Sunoco, and United Refining all posted losses in the first quarter. The hardest hit have been small refineries that tend to process the most expensive types of crude oil into gasoline. Sunoco, for example, lost $123 million in the first quarter, while Tesoro posted a $82 million loss for that period, in contrast to a profit of $116 million last year.
At Valero, the nation's largest independent refiner, first-quarter profit melted by 76 percent. Its refining capacity allows it to process heavier grades of crude oil that typically trade at a discount. Still, its profit dropped to $261 million in the first quarter compared with $1.1 billion last year."

[WayneS]

With the weakening of the U.S. dollar, the operating costs to American oil companies overseas goes up and negates any profits that might be made by higher crude prices. It IS the dollar, stupid.

[tuj]

Why is gold a 'currency' or inflation hedge? It has no intrinsic or industrial value. Just because currencies were once tied to it, why do people still think of it as some sort of magical currency anchor?

[TheStockaccumulator]

Earlier today before I read this article, I emailed the Fed governors the same points that were made in this article. Guess what? I did get an answer back the same day from the Federal Reserve Board staff! The Fed staff member actually addressed some of my points I made which were identical to this article. Sadly he ended his response with a typical silly point for me to contact my congressman, though obviously congress has no real authority to affect interest rates. But everyone should email the Fed a copy (or email address) of this great article. You can google the Federal Reserve Board web page. It will direct you to their email page. Make your comments known. Even a small noise from the Fed that the Fed is about to tighten, will send the price of of oil to about $105 ppb. I know this, as I myself as I am a successful oil trader, and I, like all traders worldwide, check the Fed situation first before deciding to keep any position. US Dollar strength (ie. rate affection news) during any period is critical to any trader's decision, worldwide. But I care about my country much more than any profit I am making, hence my reason for all to contact the Fed.

[Nickel]

I'ts not the dollar, it's the hedge funds. They put there money in oil to make there funds look better, now they can't get out with losing big, so the just keep pushing it higher. They can't make it in the stock market so push oil up and take the U.S. IN RESECTION.!

[John L.]

The US dollar has been dropping against all the worlds currencies because of interest rate cuts most recently but also because of lack of confidence by foreigners in the US economy and throw in trade deficit imbalance for good measure also.

This is attributeable mainly to Americans living too much on credit and having no financial intelligence in being able to control their spending.

As the author mentioned, not being on a gold standard results in a fiat currency which again gives the US dollar a foundation of sand.

I really believe that there is strong demand for oil as well, this defies common sense with so many countries coming on line at once.

Multiple factors all playing together.

What will change this? : raising of interest rates, Americans living within their means, lending standards tightening up, in short all the things you and I would do to balance the budget but that need to be done on a national scale by government and individuals.

It would be great if we could go back to a gold standard but there are too many greedy people benefiting from this at the expense of the consumer so I don't see this happening soon.

To fight back, buy some ETFs that invest in gold, silver or oil (oil to avoid tax consequences)

[CLH]

This is the first article I have read that is right about oil. The same thing happened in the early 1970s when the dollar first started down. People just dont learn. There is plenty of oil and no shortage.

China and India both subsidize oil. They cant keep this up and when they stop The world will be flooded with oil and the oil producers will crash as happened in the 1980s. People never learn.

[JREwing]

CLH

If I remember the 70s correctly, the Mainland Chinese rode bicycles, Indians drove scooters and Brazilians were busy dancing samba.

The story back then was an attempt by the OPEC nations (no doubt motivated by the Sowjets, since none of the OPEC nations ever gave a damn about the Palestinians) to blackmail the West. An abrupt shortage of oil led to economic chaos in the west, since oil determines the price of everything, back then even more than now.

That's a little different than 25 years of underinvestment in the oil business and tremendous physical demand from emerging nations.

Do your homework, Sir.

[WayneS]

The US oil producers did learn something. In the 70's and early 80's, they were investing heavily into alternative energies. Following the crash, there has been 25 years of layoffs, mergers and a focus on efficiency. Even though they have had 2 or 3 OK years, they are continuing to tighten their belts so they can survive another 25 years

[CLH]

JRE What you dont seem to understand is that all commodities go in cycles. When prices go up people use less of the commodity. The market is flooded even before more is produced. This always happens. The end result is that the final price is the same as it was before the spike. Alternative energy will still not be able to make a difference because oil is still too cheap.

[maher]

It's the coming Iran strikes, and also supply and demand. Not USD.

It's Iran, stupid!