US economy and rise in oil prices

Shafey Danish

Near the end of 2007, even as the subprime crisis was roiling through the US financial system, and its aftershocks were being felt throughout the world, another crisis not much noticed at the time, was fast building up. The increasing cost of oil.

Given the coinciding of the two crisis, one cannot but see a link between the two. Some factors are so obvious that they leap out at you. The subprime crsis played a large role in the decline of the dollar. Which in turn made oil priced in dollars dearer.

Another link that jumps up and bites you is the rampant speculation that is apparently taking place in the US bourses. But there are other more subtle links too.

The US for a long time has been seen as a safe investment haven for the world’s money, that took a beating after the subprime crisis. Investors are looking for safer places to put their money. That is why the price of gold has skyrocketed in recent years.

Oil, a scarce commodity, the demand for which rises everyday, is one of the safest commodities to invest your money in. Investors, reports indicate, are building up huge inventories which cannot but drive up the price of crude.

How much have the individual factors affected the price of crude?

Dollar

The dollar has been in a long term decline against the major currencies of the world for sometime now. This trend, fuelled by huge trade deficits especially with China, is not likely to be reversed anytime soon. Joseph Stiglitz in one of his interviews put the potential decline of the dollar at 30% of its present value.

If this prediction proves to be true, then the price of most commodities priced against the dollar would skyrocket. As of now one report puts the net price rise of crude per barrel because of falling dollar between $10 to $15.

Interest rates have been falling with the weakening US economy (reducing interest rates is a classical solution for spurring growth and boosting demand) but falling interest rates also means investors do not want to stock up US dollars and instead use it to buy up commodities elsewhere. One of those commodities is oil.

As more people buy oil the demand for it rises, fuelling a price rise. Also as the dollar falls against other currencies (Euro, Yen, Canadian dollar etc) oil which is priced in dollars becomes cheaper for the users of that currency.

Here is an example. Say oil is at USD100 per barrel, and USD100 is equal to 70 Euros. If the Euro appreciates against the dollar by 10 percent, then instead of 70 Euros it will take only 63 Euros to buy one barrel of oil. This way, oil becomes cheaper to foreigners, and they can buy more.

Speculation

The thing about speculation is that no one is really sure what part it is playing in the current rise in the crude prices. That it has played some part, everyone agrees. But how much? There the opinions differ widely.

Speculation has always played an important role in the trade markets. ‘Bubbles’ are always caused by speculation, which later leads to price correction. Even in normal trade, prices are speculative, given that they depend on the companies projected profits. When these profits are not upto expectation then share prices fall. Speculation very often becomes a self fulfilling prophesy. If large amounts of investment flows into a company or commodity market – based on the premise that the price of that commodity would rise – then the price of that commodity would actually rise simply because there is so much money chasing it.

Something similar has been happening with oil. Big investment companies including hedge funds and pension funds have ramped up their share of the NYMEX oil futures contracts to 71% in April from 37% in 2000.
Fadel Gheit, a respected oil analyst told the US Congress that oil prices are unnaturally high. Supply demand economics does not really justify the kind of prices seen in recent months nor is it explained by falling dollar.

"I firmly believe that the current record oil price in excess of $135 per barrel is inflated ... crude oil prices should not be above $60 per barrel," he said.

The US Congress is already considering measures to put a stop to this excessive speculation. The problem is, that after allowing the same speculation in every other commodity with the minimum of regulation even at the height of the subprime crisis, the congress would find it difficult to take a different tack on oil.