Why Crude Oil Prices have Spiked Higher

By: Andy_Sutton

Maybe it is just bad timing. Maybe our luck has run out. Whatever the case, it is downright unfortunate that the full effects of skyrocketing world oil supplies had to be realized during the silly season of a presidential election cycle. It is virtually a lock at this point that what needs to be said will be left unsaid and what needs to be done will be left undone. This week as crude oil pierced the $130/bbl mark and headed all the way above $135 before pulling back a multiple of reasons were offered. Some have merit while others do not even deserve mentioning.

Before I analyze this critical issue I will admit that I am a firm believer in the idea that energy is going to be a dominant theme in the world moving forward. Given the way we are presently clinging to the status quo in this country, it is likely that this will remain the case for some time to come. Gasoline has grabbed the headlines at $4 per gallon. Analysts have been tripping over each other to get airtime by stating higher and higher upper limits for price of both oil and gasoline. Banks have not been far behind. Amazingly, almost everyone who was short energy 3 months ago is suddenly convinced oil prices are going to the moon. They could be right. Why the sudden about face? What we are witnessing here is either a whole bunch of people trying to save face by chasing a shooting star or something of a realization that things have changed. I sincerely hope it is the latter. Viable solutions to this problem will not come overnight and every day wasted on grandstanding is another day in the future we will have to wait for the efforts of today to come online.

Unlike many mainstream commentators, I do not believe there is a single cause for the rise in oil prices. I believe what we are witnessing is the commingling of a variety of factors. Unfortunately, this also means there is no magic bullet solution to the problem. The following are some of the main themes that have gotten us to where we are and will drive this situation moving forward.

The Falling Dollar

As we have previously discussed on many occasions, the US Dollar has been under extreme pressure these past few years. The recent peak in the Dollar Index is 5 years in the rear view mirror, and we have been heading nearly straight down ever since. The overall weakening of the Dollar has had a calamitous affect on the prices of consumer goods, many of which are imported from Asia . A good percentage of our energy also comes from foreign sources. One exacerbating factor is that our oil is priced in Dollars. Were it priced in Euros, for example, the price would likely be much lower. The Dollar has depreciated against oil far faster than it has against any currency. This alone should be a red flag in terms of pinning the rise in oil prices solely on currency movements.

There is another aspect to the currency argument though. In essence we are being killed by our own monster. Since 1971 we have flooded the world with Dollars to pay our import bills. We can not expect now to control where, how, when, and on what they are spent. Those Dollars are financing an industrial revolution in Asia , and to a lesser extent, India . Put another way, we have financed those who are now competing with us for limited energy supplies. We have supplied buyers the world over with Dollars with which to bid up the price of oil and pretty much everything else. We are witnessing the workings of inflation in its purest form.

Supply & Demand

T. Boone Pickens was recently on one of the financial channels and he made the statement “We've got supply of 85 million barrels a day and demand of 87”. Simple arithmetic will tell us this isn't going to work. So up go prices. At some point, we will see destruction of demand and demand will come back to meet supply at an equilibrium price. It is critical to understand exactly WHOSE demand will be destroyed, however. This is not a US-centric issue. Regardless of our pain at the pump, we need to consider what the rest of the world is doing. If they have no ‘pain at the pump' it stands to reason they will consume the same, if not more as they bring more and more vehicles and other energy consumption online. We have no entitlement to cheap energy. There are 85 million barrels a day and they will go to the highest bidder.

Just because we consume less does not automatically guarantee that prices will come down. This line of thinking partially explains why we didn't see the expected leftward turn in the worldwide demand curve for gasoline when our prices here hit $3/gallon. Also, there is growing evidence, particularly in Australia and Canada , that some refining operations have had a difficult time accessing enough crude oil to keep things moving. Contrary to OPEC, this does not appear to be a well-supplied market. If this is indeed the dynamic, prices will continue to rise until either more supply comes online or demand falls off.

This is where the weak Dollar is really going to bite us. US consumers have a relatively stagnant supply of Dollars, yet as a nation we continue to send $60 Billion per month overseas to pay for our imports. We continue to provide the world with cash to bid up oil prices to levels that ordinary folks here in the US cannot afford to pay. Is it starting to make sense now?

Speculation

Speculation is a rather broad term. In classical investing lore, it is the notion that one buys an asset today assuming that someone will pay them more tomorrow. Speculating has also been called the greater fool theory. Risky investments are often referred to as being speculative. I am sure there are some folks in the oil markets who are chasing the shooting star; not really sure of the fundamentals or why they're buying it. I would contend, however, that most of those people are not buying futures contracts, but rather utilizing the paper-based ETFs to get exposure. Weak hands and the inexperienced are generally washed out of the futures business rather quickly. Mom and Pop putting a few bucks into oil stocks in the hopes of defraying their energy costs is clearly not causing this.

What I believe to be happening is a combination of hoarding at a national level and locking in future flows of oil in anticipation of a weaker dollar, short supplies, geopolitical tensions, and the continued growth of worldwide demand. Semantics would certainly allow any of the above to be called speculation, but what is going on today is not congruent with the classical definition.

Political

In terms of the United States , it is very important to keep an eye on the political environment. I generally avoid politics like the plague in this column, but it cannot be ignored in this case. History has proven time and time again that politicians, when faced with a crisis, generally do the wrong thing. In what could be another tragic example of this phenomenon, Senator Joe Lieberman has suggested that we throw ‘speculators' out of the commodities markets as a whole. This knee-jerk solution will have downright ugly ramifications if it is allowed to get serious consideration. First, it totally displaces the real causes of higher oil prices and secondly, it is punitive to all Americans.

Commodities are traded worldwide. Banning investors from US markets would only cause alternate markets to pop up elsewhere, most likely using a non-Dollar currency. Selling pressure on the Dollar would intensify as commodities players unloaded Dollars in favor of the currencies needed to transact business. The subsequent fall in the Dollar due to that selling pressure would effectively price most Americans right out of the energy market for starters. It would also rob inflation hawks of the ability to try to maintain pace with increasing costs by allocating capital to ‘keep up' assets like Gold, Silver, oil, materials, and recently foodstuffs. At worst, we could see the outright unavailability of essential commodities in this country.

At a time when we can afford it least, we are primed for a barrage of ‘solutions' which both lack merit in terms of an understanding of the problem, and are dangerous in terms of a lack of awareness of the potential fallout.

Listen to our weekly radio broadcast on Blog Talk Radio as we discuss this and other important issues in the economy, investing. http://www.blogtalkradio.com/my2cents

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar. For more information visit www.suttonfinance.net

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