Why Oil is Not $70 per Barrel

What is the inveterate problem as to why oil is pushing $150 per barrel and a gallon of gasoline costs four dollars per gallon? Our government is the problem. Not the Democrats nor the Republicans, but the collective net assembly of congressional and executive leaders since the 1974 oil embargo, and the negative effect it had on our economy is on their hands. There have been 17 Congressional elections and 9 presidential elections since the oil embargo of 1974. There has been energy act after energy act passed with a zero effect on not only oil consumption, but oil prices, and our ability, as a nation, to wean ourselves off fossil fuels. The 1974 oil embargo was a wakeup call to move in a different direction for fuel, but as usual, as the American populace’s outrage went dormant, so did the demand for change.

What have these 17 congresses and 9 presidential administrators done about the price of oil and the need for an aggressive search for alternative energy? Nothing but point fingers at one another with cries of illogical and inarticulate excuses as to why we are in our current state in relation to the price of a gallon of gasoline, and its effect on our economy.

The simplification of excuses, from the left: the right has perpetuated price gouging by supporting “big oil,” coddled speculators, refusing to curtail demand, and the mainstay excuse of the left–it is George Bush’s fault. And from the right: the left always, and continues, to prevent the U.S. from increasing domestic oil production by blocking drilling and the construction of new refining plants.

To listen to some economists, it is very simple: (Supply and demand is the cause of oil being $150 per barrel, stupid.”) Since the price of a barrel of oil has more than doubled from 2007 to 2008. It was $60 at one point in 2007 and just under $150 in July of 2008. The demand for oil has actually dropped since 2007, so that makes blaming supply and demand, well, sort of stupid.

So what is it? There are two primary reasons combined with a peripheral dynamic. The weak dollar and oil speculators are the two primary causes of the high price of oil. The peripheral dynamic is the U.S’s. consumption of oil. Our consumption is independent from the price of oil, but our government has continued to lead us down a path of being economically subjected to the consequences of high gasoline prices, and mired in a position of dependency on oil–regardless of the price set by speculators, or paying a premium because of our weak dollar.

Bush has done one thing, and one thing only, in regard to a positive effect on the U.S. economy, and that is the lowering of taxes, which has brought in record revenues for the government. The Bush administration has been an abysmal steward of the increase in revenue generated by the tax cuts, and furthermore, his economic policies have squandered all the newly created revenue, and then some. His economic policies have beaten the dollar into submission around the world. By trying to keep interest rates below the inflation rate, the dollar has taken a huge beating in value against foreign currency. Along with pushing the U.S.’s debt to almost 10 trillion, the dollar is beaten down even further. This has a huge impact on the price of a barrel of oil as oil trades in dollars. Economic supply and demand: too many dollars equals cheap dollars.

Some economists and some on the right are ringing their hands and gnashing their teeth at the prospect of regulating oil speculators. “It would be interfering with the free market,” they wail. Nothing could be further from the truth. Regulation of oil speculators is needed to bring the oil industry back to a free market. The oil ministries of OPEC, which do not set the price of oil, have blamed, almost unanimously, the weak dollar and speculation.

The textbook definition of a free market is defined as such: the price of goods is set by the mutual consent of sellers and buyers. In the oil industry there is no mutual consent between buyer and seller. The price is completely out of the control of the seller and buyer. The EIA (Government’s Energy Information) reports that U.S. oil demand will drop in 2008 by 190,000 barrels per day. The U.S. has already seen a significant drop in gasoline usage through the first six months of 2008, with no effect on the market price of oil.

The right keeps chanting, “drill, drill, drill.” The left keeps chanting, “no, no, no.” What will drilling accomplish in regard to relief of current high gasoline prices? Are we, as a nation, so naive as to believe that the drilling of new oil sources of U.S. crude will be sold to refineries at a much lower cost than the world market price and as a result we will see gasoline prices plummet- especially with the continued threat of the left’s windfall profit tax on the oil companies? No, the oil produced in the U.S. will end up on the world market, then it will be at the mercy of speculators and the U.S. dollar to determine its price, then it will be bought by refinery plants at the going rate. That is the system we have allowed to evolve. The supply side would have a negligible effect on the world price of oil because of the absurd prospect of our government implementing something so simple as this, and done at a high enough volume to have a more than token effect on the market. The speculators have already shown what they will do with a modest increase in supply anyway. Saudi Arabia announced that it would increase production by 300,000 barrels per day with an additional 200,000 to be added later. This would, in a free market, be the perfect scenario to drive the price of oil down. But the speculators disregarded the increase in supply and they drove the price of oil up after the announcement. So much for a free market. Consider also that the world consumes approximately 90 million barrels of oil per day, but the speculator markets are trading in excess of a billion barrels per day. Free trade works off of a balance: too much product, lower prices, too little product, higher prices. Again, the oil market is not a free market.

Another way speculators inflate oil prices is when they short trade oil by betting on the price to fall, and when the prices actually rise,  the speculators are forced to cover their positions.  This drives the price of oil up. It’s a no win situation with speculators in the market. Economically, the price of a barrel of oil is trading at double the price the free market equation would dictate. There is only one part of the economic equation that cannot justify, but can explain, why oil is $150 per barrel rather than $70. That is the speculation part of the equation.

The second scenario in which the dollar plays into the equation, and has an effect on the free market is as follows: When the dollar, which is also speculated on, starts dropping in value against other currencies, especially the Euro, speculators will short the dollar and buy oil futures long. When capital floods into a market at this high of a rate, it drive the price artificially up–then that same oil has to be purchased with a very weak dollar.

What does the free market dictate that the price of oil should be? Between $70-$80 per barrel, currently. OPEC countries will speak about the causes of high oil prices, but never will they try and justify the prices. You will not hear OPEC defend the global price of a barrel of oil. They cannot, because it is indefensible, and they are not responsible for the price. They control the majority of the supply side, but have not cut production to drive the price to its current level, nor have they refused to keep up with demand. There has not been any credible evidence, other than conjecture, that demand is out weighing supply by a large enough margin to justify the price of oil being over $70-$80 per barrel. Other than increasing production by 10%-25%, or decreasing productions by as much, OPEC has no control over the oil prices.

The trouble with speculators, other than taking oil off the free market, and doubling its value on the market, is that they can do this with as little as a 5% investment. Fifteen million dollars of oil can be controlled with $750,000. The speculator never takes possession of the oil, doesn’t use it, and only trades pieces of paper for 5% of the oil’s value. In 2007, when oil was $60 per barrel, speculators owned around 35% of oil, and all end users owned the rest. Today, speculators own over 70% of oil, and the end users own less than 30%. This incontestably summarizes why oil is trading around $150 per barrel, and thusly is poised to have a devastating effect on the world economy.  The prospect will only get worse as long as oil is allowed to be priced on speculation.

Ed Forman had a quote that sums up what would be OPEC’s worst nightmare: We change when the pain to change is less than the pain to remain as we are.

Has the world crossed the threshold of pain to change?

Oil prices that are sustained at the current prices are something that OPEC would rather not see perpetuated. Saudi Arabian Oil Minister Ali al-Nuaimi stated, “We are concerned about high prices. The market has no shortage of physical crude.” Each county has a vested interest in reasonable oil prices and subsequently cheaper gasoline prices. Alternative sources of energy are starting to achieve the type of momentum that is sustainable and will only pick up speed and garner a solid foot hold, if oil prices stay at their current levels. The consequences of a mass produced, viable alternative energy source would be a dramatic drop in demand for oil, and the subsequent drop in the price per barrel. Once enough capital, energy, and success have been demonstrated in alternate energy sources, the process will not be reversed, and OPEC is acutely aware of this.

What is the solution? Drilling is not the answer, it is merely a band-aid for the underlying problem of the need for an alternative to oil for sustainable and affordable energy, but drilling is necessary for the very short term. We need to drill where oil is available, but only with a relatively short duration of time. Drilling is the typical way for the government to address the symptoms rather than the problems: weak dollar, out of control speculation, and an anemic attempt at a non petroleum source of energy. The control of oil speculation is imperative to the short term mitigation of the financial havoc high oil prices are having on the world economy. If speculators are going to continue to invest in oil futures, then raise the actual cash investment from a nominal 5% to a true investment of 100%. To phrase it with colloquial flair–they need to have some skin in the game. This would have to be a concerted effort of the countries that regulate the exchanges for oil futures, as not all of them are regulated within the U.S. If this is not plausible, and is met with overwhelming resistance from speculators and exchanges, then flood the market with oil. There is almost, worldwide, two billion barrels of oil in strategic reserves, with the U. S. having 750 million barrels stored. If the speculators cannot be reined in, then flood the market with oil from the reserves, and bankrupt the speculators. This will shock oil back into a free market. It would work on the same principle as rebooting a computer–by rebooting, hopefully most of the bugs are eliminated and it will run smoothly, on its own.

The value of the dollar must be increased. This must be done by systematically contracting the supply of dollars, and decreasing the National debt. There would be consequences to this, but done in a methodical method, and over a determined period of time, it can be achieved. This would take the commitment of politicians over a period of time to make some unpopular decisions. One of the most biggest mistakes in the Bush administration was his unwillingness to balance the budget and attempt to eradicate the bloating national debt with what should have been surplus revenues, his tax cuts provided, and the vetoing of out of control spending by Congress.

If the above methods were applied to some degree and oil again drops to under $100 per barrel, and a deep breath is taken, the tendency of the U.S has always been to relax its ambitious quest for alternative energy. This must not be allowed to happen–because cheap gas leads to more consumption–and the cycle starts over again. The pursuit of alternative energy should be pushed until it gains enough momentum to cross the threshold of consummation.

Posted to Politics | Comments (10) | Email This Post | Tags: high gas prices, High price of oil, U.S. econimic policies