Weekly for September 9th, 2008
Almost two (2) months ago, in the July 21st edition of the Sterling Weekly, I briefly looked at five (5) issues that were weighing on the market and causing it long term weakness. Those items were 1. Political Uncertainty, 2. Financial System Weakness, 3. Taxes, 4. the Price of Oil, and 5. Dollar Weakness. In this week's edition of the Sterling Weekly, I want to address the items concerning oil prices.
The price of oil, and its seemingly non-stop march higher has been a major point of concern for the economy and the stock market. The concerns are that the price of oil will cause inflation to increase and the economy to slow down and possibly slip into a recession. You do not need to be a rocket scientist to know that rising oil prices will cause at least some goods to cost more, and that the more money that is spent on transportation and other items that have risen in price due to the higher cost of oil, the less money there is to spend on the remaining items. The big question is how much inflationary pressure will this cause, and how much will it hurt or slow down the economy?
1. The Price of Oil: The price of oil has been trending upwards since the late 1990's. I can personally remember some of the cheapest gas I ever bought in my lifetime was in the fall of 1999 when I filled up my car in Augusta, Ga. following a doctor's appointment regarding hip surgery earlier in the year. I paid $0.69 per gallon for unleaded regular gasoline. Since then price of oil has been trending higher, with an surges to the upside following the invasion of Iraq and Hurricane Katrina. during the course of the last 12 months the price of oil has risen from a low of approximately $70.00 to a high of approximately $145.00 set in July. (Price data based upon the October, 2008 futures contract, spot price data may vary slightly.) Since then the price of oil has pulled back to Friday's closing price of $106.23 per barrel.
2. What has caused the Price of Oil to Move Higher: Oil is a commodity; and the price of any commodity is primarily affected by supply & demand. Then add in the component of international trading markets and you have the effect of constantly changing foreign currency exchange rates moving the price of oil as well as the supply & demand factors. All three of these factors impact the price of oil. What I want to do is to take a look at each of those factors individually in order to better understand the movement of the price of oil.
A. Increased Demand: The world wide demand for oil has been increasing for years. This should come to no surprise to anyone. As more and more of the worlds nations have become more industrialized and as a greater number of the world's population has seen its standard of living increase, the demand for oil has increased as well. It is a pretty simple concept. More importantly, until new technologies and alternate sources of energy prove economically viable, the demand for oil will continue to increase as the population of the world continues to increase. In other words, demand is going to keep increasing for a long time to come. Economics 101 tells us when increasing demand meets a constant or declining level of supply the price of a good will continue to rise until either the supply is increased to meet the level of demand, or the higher prices of the product reduces the demand until it equals the supply of the product. In our world, as long as the demand for oil is greater than the supply of oil, the price of oil, will continue to move higher until the demand for oil is reduced enough to match the supply of oil.
B. Supply Limits: The fact that the price of oil has risen so high so quickly makes it very clear that the supply of oil has not kept up with the demand for oil over the short term. Yes, I know there is a very high probability that we will eventually run out of oil, but that is a long term issue and not the subject of this edition of the newsletter. In the near term, the problem we are facing is that a large portion of the oil that is produced in the world today comes from either older oil fields that are declining in production or is located in countries that are either poorly managed or unstable. As a result, the price of oil has moved higher as the growth in demand has outpaced the growth in supply. Simply put, we are not producing enough oil in the world today to meet the demand for that oil.
C. Dollar Weakness: The major oil exporting nations of the world price their oil in dollars. When the dollar is weak against the major currencies of the world. It will then begin to show weakness in its ability to purchase commodities that move around the world, including oil. However, while the US imports more oil than any other country on the planet, it does not import enough oil to offset its currency weakness when compared to the price other nations pay for oil. In other words, the price of oil has risen much higher in percentage terms here in the US than it has in Europe because the Euro has appreciated significantly against the dollar. So as the dollar has declined in value, and the price of oil has increased on the world market, it has risen much faster in terms of dollars in order to compensate for the weakness in the dollar. It has been estimated that as much as 1/3 of the increase in the price of oil over the last 1-2 years has been caused by weakness in the US Dollar. In other words the weakness in the dollar has added about $40 to the price of oil.
3. Oil's Impact on the Economy: Like it or not, the price of oil has an impact upon the economy. Petroleum products are used in almost every facet of our economy and our lives. The price of crude oil impacts the cost of these products. The rising price of oil impacts our economy in three (3) very negative ways that I have touched on below.
A. Inflation: Simple economics says that when the cost of a products raw materials rise, so eventually will the final cost of that product. The Producer Price Index which essentially measures the wholesale price of goods is up year over year 9.2%. Like it or not, that is inflationary pressure, and too much inflation is bad for the economy. (Additional info on the PPI can be found here) The rising price of oil increases inflation in our economy which eats away at our assets and reduces our standard of living. This is a bad thing for us and the world.
B. Slowing Economic Growth: Economic growth as measured by the Gross Domestic Product (GDP) has slowed from its post 2001 peak of just over 4% to around 2% for this year. The good news is that the US economy is still growing and it is not in a recession. The bad news is that the growth rate of the US economy has slowed enough to where it is causing some people, but not all, some discomfort. It is fairly obvious that rising oil prices, and high oil prices are bad for the US economy. Also, high oil prices tend to hurt lower income people the most as they have the least amount of discretionary income. (Additional information on the GDP growth rate can be found here)
C. Wealth Transference: The high price of oil is causing a large transference of the wealth of this country to those countries that we import oil from. The shifting of this wealth overseas is not a good thing for this country. It will ultimately lead to a lower standard of living here in this country, and it will ultimately enrich nations that do not share the same values as us. These nations will seek to do things that result in a gradual destruction of the wealth and power of this country. This will hurt the income levels of people in this country and further reduce our standard of living. We must actively seek to counter this wealth transference through free market forces.
4. Lowering the Price of Oil: Like it or not, we need to reduce the price of oil on the world markets. This is vital to the long term economic health of this country and its citizens. In order to reduce the price of oil we must take steps to address all the factors that have contributed to its movement upwards. This means reducing the demand for oil, increasing the supply and strengthening the dollar in foreign currency markets.
A. Increased Drilling: Increasing the supply of oil will help bring down the price of oil. In order to increase the supply of oil we will need to do many things including the development of new technologies to get more oil from older oil fields, and we will need to open up more territory within the United States to drilling. Plain and Simple. We need to recover the reserves we have in the ground, where ever they may be.
B. Alternative Energy: Alternative Energy is important to reducing the price of oil. There are two facets of alternative energy. The 1st is to make things more efficient than they already are so they use less energy, and the second is to develop substitute energy sources. Making things more efficient will help us stretch the resources we have, but it will not eliminate our need for those energy sources.
Alternative fuels will be a critical factor in reducing the demand for oil, and eventually replacing oil as our primary source of energy. I have consulted on several alternative energy company projects, and I can state with a great deal of confidence that the alternative fuels that eliminate our dependence on oil are not going to be today's technology. We are still a long way off on several key technologies from seeing them become economically viable. Battery technology is not up to the task, and bio fuels are nothing more than an emissions additive to clean up hydrocarbon based fuels. There simply is not enough land to grow all the plants necessary to make enough ethanol or bio diesel to have a significant impact upon our oil consumption. The alternative fuels of the future are going to need to be clean, and renewable. This means they are most likely going to involve hydrogen and some form nuclear fusion power. The important thing is that the due to the spike in the price of oil that we have just went through the proverbial genie is out of the bottle when it comes to replacing oil as our main source of fuel. And like the genie that once it is out it doesn't want to go back in the bottle, our need to develop alternative fuels has now been recognized and isn't going away anytime soon.
C. Foreign Policy: This is a tough one, one that has been neglected for a long time, but one we can't ignore any longer. The vast majority of the oil in the world is under the ground of governments that either don't like us or are hopelessly unstable. Think of Iran, Venezuela, and Nigeria. It's not that the people who live in these countries don't like us, it is that their governments don't like us. But governments can be influenced and changed. The US needs to develop and implement a foreign policy designed to stabilize and assist those countries. This will minimize supply disruptions such as those that constantly occur in Nigeria, and allow the location of new sources of oil such as recently happened in the Kurdish areas of Iraq
D. Strengthen the US Dollar: Just as dollar weakness has contributed to an increase in the price of oil, so will strength in the dollar contribute to a decline in the price of oil. Nothing demonstrates this more clearly than the recent pullback in the price of oil following the Russian invasion of Georgia and the upward movement in the dollar. The price of oil immediately went lower as the dollar strengthened. We need to take steps to provide long term strength to the dollar. A strong stable currency will lower the price of oil, and keep it lower in terms of relative purchasing power. I will discuss how to do this in next week's edition of the Sterling Weekly.
It should be very clear to everyone that the high price of oil is not benefit the United States, it citizens, or the citizens of almost any other nation on the planet (with a few exceptions). We need to take steps to reduce the price of oil, and to ultimately eliminate our dependency on oil. The key to doing this is to increase the supply of oil by increasing the area of the world that can be drilled for oil. This will be accomplished by opening new areas of the US to drilling, improving technology, and by stabilizing unstable governments around the globe. In addition to this we must reduce our demand for oil by the development of long term alternative fuel sources that are clean, renewable, and economically viable. Finally we must move to permanently strengthen the US Dollar. These steps will allow us to have a healthy growing economy that allows us to develop the new technologies that eliminate our dependence on oil and lead us into the twenty second century. In case you hadn't noticed we are already in the 21st Century, and what got us here will not get us out of here.
In the upcoming editions of the Sterling Weekly I will be taking a look at the other four (4) issues I feel are weighing on the market. If you are not a subscriber, please be sure to sign up in order to see our upcoming comments.