2007-08-19

Oil at $100 per barrel?

Peakniks (those interested in Peak Oil), have often used the spectre of $100 per barrel of oil as a potential outcome of the Peak. "Look at the price of oil", they would say, "you think it's high now? Wait until it hits $100 per barrel".

The "$100 per barrel" argument is an interesting one, mainly because it represents a landmark - an important sign along the way that proves Peak oil to be both scientifically and economically correct. After all, if oil production begins to decrease (as Peak Oil argues will happen), then the result will be higher prices.

One of the landmarks that has been approached twice - but never passed - is the $80 barrel mark. I have read elsewhere (and please forgive my not linking because it would take too much time) that $80 is the inflation adjusted price of oil that is comparable to the highest price reached during the oil shocks of the 1970s. Twice in the last few years the price of oil has been above $79 but has never gone past the magic $80. As a landmark, such a price indicates that the world is, indeed, in an oil shock.

But will the price ever reach $100? I was chatting with Dave about this recently and I pointed out that the chances of this occurring were quite slim. At the moment, the United States is undergoing the "Subprime meltdown", which is a severe economic shock. I am fairly confident that this event will plunge America into a recession and maybe take parts of the world with it. Moreover, I am of the opinion that the oil price has been so high for so long that the knock-on effects - namely inflationary pressure and higher interest rates - have been in many ways responsible both for the recent US housing bubble "popping" and the Subprime meltdown which has followed.

This being the case, the fact is that with a recession now already in the works the chances are that inflationary pressures will drop markedly. With a recession reducing the power of Americans to purchase goods and services, one natural decrease will be a drop in oil demand - an event that will result in lower prices.

So, my argument went, the chances of oil reaching $100 - at least within the next 3-5 years - is actually quite slim. Had things remained more or less the same, I would stand by this prediction.

However, I have since changed my mind - quite quickly I might add - because something happened that I did not predict that messed up my thinking on this issue. What was that "something"? It was Ben Bernanke.

Ben Bernanke is the chairman of the US Federal Reserve Bank - a post once occupied by Alan Greenspan. Last week, as you probably know, US Sharemarkets were taking a hammering from the Subprime meltdown - the market was unwilling to lend struggling mortgage brokers the money they needed to keep their businesses running, a process called a "credit squeeze". With the market in trouble, Bernanke came to the rescue by lowering a key federal funds rate, a process which essentially communicated to the market that the Fed's monetary stance is now expansionary. In other words, the Federal Reserve will increase the money supply, thus making money cheaper, with the result being an easing of conditions for the entire marketplace.

When Bernanke made this announcement, I could scarcely believe it. I posted my thoughts on this the other day and I am still in shock.

Back when the Asian financial crisis was unfolding a decade ago, Alan Greenspan responded to the situation in much the same way - by an aggressive lowering of US interest rates. Greenspan has been cre
dited with preventing a world recession as a result. This time, however, rather than the United States Economy rescuing the world from recession, it is more likely that the US will drag the world into a recession. Overseas investors have been slowly selling off their US Dollar assets for 2-3 years now - the result being an increasingly weak US Dollar. This weak dollar has been partly responsible for the rise in US inflation and a rise in US interest rates - both of which have exacerbated the current Subprime meltdown.

What I am trying to say is that the Fed's action in lowering interest rates and expanding the money supply is exactly the wrong solution. The Subprime meltdown started because money was too cheap - so making money even cheaper will not solve the problem. Oh, it may give the market a temporary fillip, but the medium-long term outcome will be increased inflation, a weaker US Dollar and increased pressure to raise - not lower - interest rates.

So what's all this got to do with the price of oil?

If the US Dollar devalues then the price of oil will go up accordingly. International markets have responded to the Fed's lower rates by selling off the US Dollar - and they will continue this process. With an ever-devaluing US Dollar, the only way is up for the price of oil.

On Thursday last week I predicted that oil would not go over $100. Since then Ben Bernanke has messed up my calculations and basically said to me (and the rest of the world) that the US Dollar is not worth owning at its current price. With a devalued US Dollar now an almost certainty, the chances of oil breaking the $100 mark is now much more likely.

When the news of the Fed's action hit, I immediately went to an economics blogsite called "Calculated Risk" where I was able to read and contribute to the discussion about the Fed's action. Most of the commentators at the blog were of the same opinion as mine - that the Fed had made a huge mistake. I left this comment which I think sums up the potential future:
Imagine - America is in recession and the Fed has to increase rates to battle inflation. Not good.

© 2007 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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