April 23, 2011

Gasoline and Dollars: Supply and Demand

By Steve McCann

Gasoline has exceeded or approached $5.00 per gallon in some parts of the United States long before the normal peak travel season has begun. Already the politicians, headline writers, and some cable and talk show pundits are pointing to the usual suspects. But they have avoided or are unaware of where the fault actually lies.

One of the foundational tenets of economics is what is known as the law of supply and demand. Normally whenever a product or commodity is in short supply the cost to acquire it increases; on the other hand, if there is a glut on the market the price decreases. However, over the past three years, thanks to the profligate fiscal policy of the Obama administration and the Democrats in Congress combined with the money creating monetary policy of the Federal Reserve, this law has been turned on its head.

There are two commodities deeply affected: the first is oil, which is a basic modern day necessity; and the second is gold, which has always been a safe haven against economic downturns that reflect this upside down world.

The fluctuations in the price of oil have been primarily demand-driven, and to a lesser degree impacted by world conditions which is reflected in supply. Since 2003 world oil production has maintained the following relationship with global oil consumption.

Year	Ratio	Average Price per Barrel (adjusted for inflation)
2003	97.0%	$38.66
2004	97.7%	$39.87
2005	97.4%	$48.29
2006	96.7%	$69.94
2007	95.1%	$65.74
2008	96.4%	$88.40
2009	95.0%	$87.60
Current	98.8%	$110.00

Source: http://omrpublic.iea.org

As a general rule, the above table follows the anticipated supply and demand equation (with slight variations due to political or weather instability etc). That is until the present, where the correlation is completely thrown out the window. Despite the ongoing stalemate in Libya and general unrest in the Middle East, supply is keeping up with demand. This was underscored by the Oil Minister of Saudi Arabia when he recently announced that the Saudis were cutting production by 700,000 barrels per day due to "market oversupply."

While it is always fashionable and populist to blame the "speculators" and oil companies, those entities are fully aware of the supply situation and would not be taking undue risk when a futures contract in that market situation could easily backfire on them. But they are also aware that another factor has come into play. That is the wholesale creation of money by the Federal Reserve in response to the massive deficits run up by Washington D.C. In reality these are quixotic attempts by both entities to jump start the US economy. Their most significant accomplishment in doing so is to enrich Wall Street and the huge financial institutions deemed "to big to fail" at the expense of the American people.

Oil, as are all worldwide commodities, is denominated in US dollars. The dollar is also the world's reserve currency. What happens in the corridors of power on the banks of the Potomac has an immediate and potentially devastating impact on the rest of the world.

Gold, which has been considered a safe haven and hedge against not only inflation but the follies of an unrestrained government, reflects more dramatically than any other commodity the effect of Federal Reserve policy. During 2007 the average price of an ounce of gold was $695.00 an ounce. In the past week the price has hit $1,509.00, more than double the 2007 price or increased by a factor of 117%.

It is no coincidence that during this same period the Balance Sheet of the Federal Reserve showed assets of $825 Billion throughout 2007; however today it exceeds $2.7 Trillion, a phenomenal increase of 223% or more than triple. Of the $1.8 Trillion increase is $1.4 Trillion of US Treasury debt that the Fed bought and in essence printed money to do so. This has flooded the marketplace with US currency and driven up commodity prices across the board. Additionally this tsunami of greenbacks has created massive problems for emerging countries as the influx of dollars looking for higher returns has overwhelmed their economies, triggering inflation and currency and exchange rate problems around the world.

The Fed, in league with the federal government, chose this course of action in order to underwrite the ongoing crippling deficit by buying the bonds of the US Treasury, which had to be offered as the result of fiscal policies that were supposed to stimulate the economy. The Fed justified their actions by claiming this program, also known as quantitative easing, would make more money available for borrowing by the private sector. It has done neither. Instead it has sown the seeds for stagflation (high unemployment coupled with high inflation).

In the meantime the dollar has lost a considerable amount of value as compared to other currencies. Among the most stable of currencies over the years has been the Swiss franc. In 2007 the exchange rate was 1.22 francs to the dollar; today it is 0.881 to the dollar a decrease of nearly 25%, a drastic drop in the world of currency values. While it is nearly impossible to accurately measure the true impact of currency devaluation and acknowledging that there are always other factors at play, a simple exercise using the Swiss franc and the US dollar relationship applied to the cost of a barrel of oil today reveals that a cost of that oil would be $82.50 instead of $110.00; much more in line with historical patterns.

The fault for the nation's present predicament lies solely at the feet of the federal government, from its spendthrift fiscal program and obstinate refusal to develop America's vast oil reserves, to its Russian roulette monetary policy. As for the evil "speculators," they are indeed speculating on the future rise in the price of oil and gold, but not because of traditional supply and demand factors, but because they are convinced that there is no will in Washington to rein in spending, and that the Federal Reserve will be forced to do another round of quantitative easing exacerbating an already dire situation that can only end in disaster.