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Oil prices, trade deficits, interest rates, and inflation - facts and fictions

In an August 6, 2004 "Futures Movers" article for CBS MarketWatch.com(1) Myra Saefong discusses factors influencing expected oil prices, as they are represented in the futures markets.  In addition to inventories of oil, with the US holding around 300,000 barrels and still adding to the Strategic Petroleum Reserve, she addresses political and broader economic influences.

The "Yukos Flap" in which the large Russian Oil company Yukos is under pressure due to the Russian government's assessment of taxes and penalties for tax evasion has been considered one factor leading to uncertainty and an increase in oil futures prices.  (Yukos took advantage of tax benefits designed to reward actions and investments in underdeveloped outlying areas of the country - but never took the actions or made the investments which were the basis of its claimed tax credits.)  As that controversy approaches resolution, the uncertainty premium in oil pricing will decrease, and variations in daily impressions of the status of the controversy are significant influences on price.  Naturally, the oil speculators love to talk about the "crisis" in ways that increase the uncertainty and overall prices and profits, so this issue gets far more concerned attention than it deserves, and contributes disproportionately to futures pricing variations.

As the article puts it:

Global oil production concern continued, however, as tax debt problems at Yukos lingered.

"Oil prices reacted strongly [Thursday] to Russia's sudden reversal as they decided to keep Yukos's assets frozen," said Phil Flynn, a senior analyst at Alaron Trading in Chicago.

Yukos (YUKOY: news, chart, profile), a 1.7 million-barrel-per-day oil producer, said Wednesday that the Russian government would allow it to use its frozen bank accounts to fund operations in the face of billions of dollars in tax debts, but the government rescinded the permission Thursday.

"What's at play is essentially the world's excess oil capacity," Flynn said. "Russia continues to flex its muscles, and only the health of the world economy hangs in the balance."

Yukos has said if its assets aren't unfrozen, it would have to cease production sometime in mid-August. This is some of the "very last excess capacity in the world," Flynn said, adding that while OPEC has some spare capacity to cover it, if it does, it'll leave the market "extremely vulnerable."

Based on my own reading of the Yukos situation and overall oil supply situation over the last few months it appears that the situation is both exaggerated by the analysts and reporters - who are far from disinterested parties - and exacerbated by national political policies and actions.  Neither the US government, which is a wholly owned subsidiary of the oil industry under the Bush regime, nor the Russian government, which is (and has been for many years) dependent on oil export income for a major part of its revenues have any inherent interest in actions which would lower oil prices.

In the case of Russia, one could make a case for high oil prices being in the national interest.  In the US, it is harder to make a that case - the argument is contaminated by the disproportionate benefits to major oil companies and the ties of the Bush regime to those companies.

When oil analysts such as Mr. Flynn assert that "the health of the world economy hangs in the balance" because of Russian oil policies and Yukos's tax problems, I lose patience.  This statement is based on an implied, and nowhere demonstrated, presumption that the Yukos production alone is both required and sufficient to prevent oil price increases which would endanger the world economy - which is nonsense. 

First, the oil involved, though significant, is not so great a part of the total needed that its loss would increase prices a great deal - all of the price increase which would result from loss of Yukos supply has likely already been incorporated into the "uncertainty premium" currently included in oil prices.  

Second, the sensitivity of prices to supply is exaggerated in the short term by the statements of oil speculators and analysts who have an interest in those prices, and whose version of reality is uncritically reported by an unsophisticated press.  In fact, energy consumption does decrease as prices rise, and that decrease reduces demand and stabilizes prices. 

If it were not for the influence of political uncertainties produced by the Iraq War and the diversion of large quantities of oil into the US's Strategic Petroleum Reserve, even over wrought hand wringing by the analysts and speculators about the Yukos flap would not justify the uncertainty premium currently added to rational prices for oil.

$50.00 Crude.  But the CBS MarketWatch article goes beyond that, to assert a spector of $50.00 oil and higher.  Quoting the article:

Then there's OPEC. "Two days ago, OPEC President Yusgiantoro said OPEC has virtually no more oil available," said Todd Hultman, president of Dailyfutures.com, a commodity information provider. "Now he says that OPEC is considering a 1.5-million-barrel-per-day production increase when it meets next in September."

With all the conflicting information, "traders are starting to ignore these comments and more analysts are saying $50 crude is coming," he said.

The bottom line is: "U.S. crude inventories are low, world demand is strong, and there are serious doubts that producers can supply much more in the near term," he said. "It is a classic recipe for higher prices and, yes, $50 a barrel is not unreasonable."

While it would have a significant psychological impact on public impressions, $50 oil would not be the disaster implied by the people quoted.   That price very well may be reached, and it won't be the end of the world economy if it is. 

Which is apparently an obvious enough truth, that there are those who think the possibility of that price is not sufficiently alarming.  These people are led to describe even more dramatic scenarios -- dollar devaluation accompanied by hyperinflation.  The anticipated public and political reaction to these scenarios, predictably enough, fit the interests of the oil companies quite well. 

Oil and the Dollar:  Oil producing countries sell oil for dollars,  and oil consuming countries need dollars to buy oil.  Consequently, the value of the dollar on the world currency market has a significant impact on the ability of countries to buy oil.  It also affects what oil producing countries can buy with the dollars they get when they sell oil.

Over the last 18 months or so the dollar has declined in value, slightly, with respect to other currencies.  One analyst wants to blow this up into a real crisis, with implications for the price of oil itself.  Quoting from the CBS MarketWatch article again:

There actually may be no limit to how high prices can go if the U.S. dollar continues its decline, said Peter Schiff, the president of Newport Beach, Calif.-based investment firm Euro Pacific Capital.

Now I am scared! 

In fact, Mr. Schiff has a considerable ax to grind - an unacknowledged agenda - in proposing such an unrealistic interpretation of recent history and prospective changes in the value of the dollar.   Though his language is extreme, the much more temperately expressed concerns of Alan Greenspan and the Federal Reserve Board lead those august representatives of our political establishment to the same, questionable, policy prescriptions.  

Mr. Schiff is straightforward in his opposition to decreasing the value of the dollar.  Instead, he would strengthen it by raising interest rates.  Raising interest rates would in fact have several effects, and one would be to strengthen the dollar relative to other currencies.  In addition:

  • It would make US exports, including agricultural and manufacturing products, more expensive and reduce demand for US products.
  • It would increase the cost of US labor relative to foreign labor and increase the rate at which jobs are exported to other countries.
  • It would suppress investment in US productive capacity.
  • It would suppress domestic consumption and demand, and risk a cycle of deflation and contraction in US economic activity.
  • It would reduce the cost of imported goods and services.  Rightist propagandists would point to this as a benefit to the consumer.
  • It would reduce the cost of oil, and prolong the dependence of the US economy on imported oil - oil paid for by the export of jobs and reductions in domestic consumption and investment in domestic productive capacity.
  • It would increase the profits of oil production and marketing companies.
  • It would slow the rate of development and adoption of alternative energy sources and more efficient energy utilization technologies.

On the other hand, keeping interest rates low would largely have the opposite effects:

  • The dollar would be "weaker" relative to other currencies, which would become more expensive or "stronger".
  • US agricultural and manufacturing exports would become less expensive and demand for US products abroad would increase.
  • US labor would become less expensive relative to the cost of labor in developing countries, and the rate at which jobs are exported would decrease.
  • Investment in US productive capacity would be cheaper, the return on investment would be higher, and investment would increase.
  • Domestic demand and consumption would increase, with a risk of a cycle of inflation and expansion in US economic activity.
  • The cost of imported goods and services would increase, adding to any general price inflation that occured.
  • The cost of oil would increase, accelerating the drive toward reduced reliance on imported oil.  Much of this increase in oil price would be offset by increased domestic income, resulting from the increased employment levels, and by reductions in energy consumption.
  • Reductions in the profits of oil production and marketing companies would be offset by increases in the profits of manufacturing, retail, and agricultural enterprises.
  • The rate of development and adoption of alternative energy sources, and energy efficient technologies would be accelerated.

Interest Rates, Dollars and Trade.  A very high dollar valuation for foreign trade exchange reduces the costs of imports and disadvantages US exports, and has resulted in our immense balance of trade deficit. 
The U.S. trade deficit for goods in 2003 was $549 billion. That equates to a loss of $1.5 billion a day, or $1 million per minute in U.S. wealth.  Every dollar of that deficit represents money we are borrowing, in exchange for the privilege of exporting jobs and income to other countries.  As long as the dollar is maintained at an artificially high value relative other currencies, this hemorrhage will continue.  (2)

Ideally the dollar should be at a value that permits US exports come into balance with US imports, and we achieve a neutral or positive balance of trade.   Monetary policy should be designed to support US exports, and bring the balance of trade into balance.  However, due to economically extraneous factors, including the perception of economic, financial, and political stability in the US, the desirability of storing value in US dollars may be so high that cash inflows to the US will continue even in circumstances where trade comes into balance, which would result in a positive balance of payments.  Equilibrium at a slightly negative balance of trade, and neutral balance of payments might be a more desirable goal.

For similar extraneous reasons it may be difficult, in the near term, to achieve the needed reduction in the value of the dollar to bring our balance of trade/payments into anything near a neutral position.  But clearly, it is essential that our monetary and fiscal policy be designed to reduce the rate of increase in our trade deficits - and that may require strenuous efforts to hold down interest rates, even at the risk of inflation above the rate that the Federal Reserve Board has traditionally considered prudent.

Typically, monetary policy is designed to result in what is called a "positive real rate of return" on interest bearing instruments (investments).  Such a PRRR is possible only when interest rates exceed the rate of inflation, which can be thought of as the general rate of increase in prices, equivalent to the rate of decrease in the purchasing power of the currency.  The closer the interest rate is to the rate of inflation, the less the incentive to save or to lend money.   However, in a global economy where money flows from the wealthiest corporations and oligarchies throughout the world into the US because of a combination of "safety" (as in Pinochet's Riggs Bank accounts), security and stable rates of returns on the money stored here, the value of the dollar will tend to stay high even if interest rates are low. 

The higher rates get, the more money will flow out of these poorer, more oligarchy ridden developing economies into the US.  This flow of money was the source of the funds the US used to pay for its deficits resulting from the budget excesses of the Reagan years, and it is now apparently the Bush regime's plan to tap that same source of funding to pay for its massive tax cuts and the expenses of the Iraq war.  In the absence of such an external source of funds, massive budget deficits create price inflation, and demand additional increases in interest rates to maintain the PRRR that is so hotly desired by the banking industry and its monetary management bureaucracy, the Federal Reserve Board.

During the Nixon administration, the hangover from the Johnson administration's  VietNam war deficit created a period of inflation accompanied by a stagnant, low growth, high unemployment economy from which the middle class of the US has never recovered.  In that case, inflation was to have been controlled by high interest rates, but instead of the anticipated action of the interest rates attracting money from overseas, they only slowed the rate of domestic growth by reducing the competitiveness of the US economy.  Prices increased, along with interest rates, while economic growth, employment and wages were suppressed by high rates of interest, reduced profits and income expectations, and increased costs of capital investment.

If the Federal Reserve uses the same strategy to deal with the deficit hangover from the Iraq misadventure, this scenario of stagflation will be played out once more.  An alternative approach, more suitable to the situation but carrying with it the risk of higher inflation over a briefer period, is to hold interest rates down to encourage the economic growth, wage growth, capital investment, and domestic consumption that can improve profitability, productivity and competitiveness needed to avoid the stagflation scenario.   In such circumstances, maintaining interest rates low enough to produce even a negative real rate of return for limited periods can be warranted.   (Switzerland, during a period when foreign funds inflows were distorting the value of the Swiss Franc - (it was too "strong" - and damaging the competiveness of Swiss exports, once imposed negative absolute interest charges on foreign funds held in Swiss banks.)

Mr. Schiff is not content with generalities in blaming his vision of impending disaster on a "falling" valuation of the dollar, he gets into some pretty far fetched detail on the topic:

He's in the camp that sees oil prices of $50 by year's end. But "oil prices next year are going to head north of $60 a barrel and just continue on up," he said, adding that he even sees $80 to $100 oil over the next few years.

"A lot of it is a function of the depreciating value of the U.S. dollar, which is going to continue," he said. It's not oil getting more expensive -- "it's just the dollar becoming less valuable and therefore more dollars are required to buy a barrel of oil."

The problem will grow as the U.S. continues to flood the world with dollars. It'll be increasing global demand for oil at the same time because "as the dollar becomes less and less valuable, oil becomes cheaper and cheaper for everybody outside of America," he said.

Mr. Schiff's argument that declines in the foreign exchange value of the dollar are responsible for oil price increases depends on an absolute relationship between the value of the dollar and the price of oil, implied by the second of the three paragraphs, which simply does not exist.  Since oil is bought and sold with dollars it is equally true, and and more plausible, to assert that a "depreciating value of the U.S. dollar" dollar always would make oil cheaper to non dollar economies (less expensive dollars equate to less expensive oil).  And Mr Schiff does make that assertion in the very next paragraph!   (Problems interpreting Mr. Schiff's reported comments may be with the reporting, more than the comments.  His July 30 essay on this topic is coherent, and worth reading.)

The point there that "as the dollar becomes less and less valuable, oil becomes cheaper and cheaper for everybody outside of America", is unarguable.  Though he seems to regards this as a negative outcome, and I regard it as a positive outcome, my argument is not with that point.  Rather, it is whether the scenario he describes has begun to happen at all.  The slight decrease in the value of the dollar relative to other currencies which has occurred over the past year or so is just not significant enough to have had, or to have the effect he describes in the future.  

(The oft mentioned "40% decrease in the dollar's value against the Euro" in the last year is not a real decrease in the dollar's value at all.  It is an artifact of an irrational and unsupportable decline in the value of the Euro in the months just after that currency was adopted.  The "40%" calculation only works if calculated against the bottom of that shortlived crash. Oil prices increased for Eurpeans during that crash, and have decreased since.  The costs of imports of US goods to Europe did the same, damaging our exports during the crash, and helping us export as the Euro has recovered its value.)

The US is not really flooding the world with dollars, at least not enough to drive the dollar down effectively.   Flows of money back into the US are still compensating to some degree for outflows needed to pay for the goods and services we are importing.  The value of the dollar is still so high that we are running a massive trade deficit, importing far more than we export.   Only when the value of the dollar achieves parity with other currencies will we pay enough for imported goods, and earn enough from exported goods, to bring our trade account into balance. 

In fact, the price of oil will continue to be determined by the demand for oil relative to supply, plus whatever "uncertainty premium" is added by the market. Of course, as the dollar declines in value and becomes cheaper for non dollar economies, their demand for oil will increase - and the value of the dollars obtained by sellers of oil will decrease.   Economic theory says that these two facts together might affect overall supply and demand and prices.

But the recent increases in oil prices are not driven by the dollar's slight decline in exchange rate.  It is economic expansion in developing countries, not a decrease in the value of the dollar, that is driving their demand for oil.  And it is the war in Iraq, and political uncertainties in Russia and Venezuala, that undercut the perceived reliability of oil supplies and add that very high "uncertainty premium" to the price.

But Mr. Schiff goes even further, according to the article:

And it won't end there. "We have the chance for hyperinflation in the U.S. if the government doesn't get its act together, if the Federal Reserve stays behind the curve and doesn't dramatically increase interest rates above the rate of inflation substantially," said Schiff.  If the Fed doesn't take action, then hyperinflation could send oil to $100 or more and "everything will be getting more expensive -- food, anything that we consume," he said.    
Here he is calling overtly for a very large PRRR, ostensibly to avoid hyperinflation.  Already, the Feral Reserve Board (intended) has raised interest rates for a second time in 6 weeks, in the face of a very low rate of job growth and continuing losses of wage income.  This is, in fact, a recipe for another round of Nixonian stagflation, and possibly even deflation and depression of the US economy.   The degree to which Mr. Schiff's comments and thinking are wandering out of orbit is apparent in the last sentence, which simply has no logical structure to analyze. 

But after all - he is an oil investment analyst.  Let's give him a break.

Addendum - Notes, Disclosure and Reservations:
Its fair to note that an article in the August 11, 2004, Chicago Tribune quotes a Chicago investement banking economist's assertion that holding the Fed's benchmark rate below the rate of inflation for an extended period would be a "recipe for stagflation [a stagnant economy with high inflation] and disaster."  This is not my view, and I think that a careful look at precursors to the "Nixon round" of stagflation would support me - but I am relying on memory and have not checked the numbers.

Peter Schiff has a quote - typically dramatic and gloomy - in the same article. 
Another bearish statement came from Peter Schiff, president of Euro Pacific Capital Inc., a California investment firm, who claimed the U.S. economy is beset with many deep problems, including heavy consumer debt, a housing market "bubble" and too many heavily indebted corporations. He said a deep recession is inevitable, and the Fed should bring it on more quickly to "purge all the mistakes of the boom."
Mr. Schiff has a rep.  He "bears" watching, methinks.  A comment at the (most excellent and very highly recommended) "Capital Spectator" blog  (comment) notes about one of his essays "As a piece of financial commentary, Schiff's piece about as rhetorically unhedged as you can get."  Here, true to form, he has written (July 9, 2004) :
"Today, the only reason the U.S. remains the world's leading economy, is because the dollar still serves as the reserve currency. However, if market fundamentals can ever manage to re-assert themselves, this is a reality that can, and indeed must, change."
Despite my lack of agreement with Mr. Schiff on many points, he has a distinctive, fact based and value driven point of view which is worth becoming familiar with.  It leads him to present information that is not given enough attention in normal financial and economic news reporting, or, in his judgement, in policy formation.  His critique of current policy is especially useful, as it strips the basic tendencies of Federal Reserve policy bare of their cloak of moderation, and exposes the direction in which the Fed is moving and the potential consequences.  (Neither fast enough, nor with draconian enough vigor and clarity, according to Mr. Schiff.)  See his July 20, 2004, essay for more.

I must note that his observations about inflation, and they way it is understated and misreported, both in the press and by official Washington, concern me.  His observations fit with my own, and lead to a conflict between my objective of reducing the valuation of the dollar and the need to do so without producing a cycle of extreme inflation.  

The goal of limiting the rate of inflation is assisted, in the case of oil price driven inflation, by the fact that increasing oil prices suppress economic activity in much the same way that increases in the cost of money, that is interest rates, do.  Quoting an August 16, 2004 New York Times newsletter by Jonathan Fuerbringer:

Of course, the threat is that the price of oil - which hit $46.58 on Friday - will stay around $45 a barrel for some time and slow growth so much that there is no inflationary threat at all. . . .

The C.P.I. for July, which will be released on Tuesday, is likely to rise 0.2 percent, according to Bloomberg. But if the index jumps more than that, investors could be less worried than might be expected.

That's because high oil prices may already be slowing economic growth - and thereby curbing inflation - more than Fed policy.

Mr. Schiff wants to avoid the inflationary cycle, and hopefully hold down the price of oil, by increasing interest rates.  I have noted above the highly negative effects of such an increase, including the perpetuation of undesirably high valuation of the dollar.  At the same time, holding interest rates down, while having the desirable effect of reducing the value of the dollar, is in effect walking on a knife edge.  If Mr. Schiff were correct the amount of inflation he predicts would be a disaster for Americans on fixed incomes.  But Mr. Schiff is not an unbiased observer, he has dogs in the fight, and reasons to advocate high interest rates. 

And higher oil prices may be an acceptable stand in for higher interest rates in their effect on inflation, while offering long term advantages to US employment and export activity.

The same "Capital Spectator" Blog (here) notes Bill Gross's "latest missive".   I have a very high regard for Mr Gross's analysis and recommend reading all the way to the 'Goldilocks yield' reference, w which addresses that troublesome "knife edge".  Note especially two startling charts:  "Total Credit Market Debt (all sectors) as % of U.S. GDP" -1915 to 2005; and "Financial Sector Profits as a % of All Domestic Corporate Profits" - March 1977 to September 2004.

Jim Pivonka
August 11, 2004
Rev: August 16, 2004

Oil futures end below $44 a barrel
Some analysts look to Russia, dollar, and see $50 oil

By Myra P. Saefong, CBS.MarketWatch.com
Last Update: 3:29 PM ET Aug. 6, 2004  
Myra P. Saefong is a reporter for CBS.MarketWatch.com in San Francisco.

June Trade Deficit Shock.  August 13, 2004, the US trade deficit was headlined as "US trade gap explodes to record in June".  The reported deficit "exploded to a record 55.8 billion dollars in June, the sharpest deterioration in more than five years". This "shattered the previous record deficit in April of 48.2 billion dollars."  Quotes from people with special interests in the topic include  "The trade deficit soared to simply incomprehensible heights in June," said Naroff Economic Advisors president Joel Naroff.  And "It is just a phenomenal deterioration for one month in the trade balance," said BMO Financial Group senior economist Sal Guatieri. 

The causes of this sharp decline assigned by the commentators do not hold up to examination - one noted that higher energy prices may have resulted in a softening of the world economy, but that runs counter to both statistics available on other than US economic performance, the fact that the oil price runup is largely in futures, not current or "spot" prices, and that the price runup is in dollars, not local currencies.  What does happen is that paying for oil uses dollars that might otherwise be used to buy US products. 

And in fact, US exports declined, not because of a softening of the global economy, but because the need to pay for oil used  dollars that might otherwise have purchased our exports.  Of course, the US had no such problem - as the "reserve currency", pushed to the boiling point by a flood of dollars from oil transactions, a huge government budget deficit, and consumer spending driven by refinancing of the US housing stock, dollars were in plentiful supply.  And overvalued relative to other currencies.

As a result, US imports climbed 3.3%, to $148.6 billion.

Appropriately, the dollar lost some value on this news.  But no where nearly enough.   The Fed foolishly projected its intention to continue supporting the dollar's value by raising interest rates.  This will perpetuate and worsen the imbalance,   reducing the relative price of oil to the US and increasing it to other countries - who might otherwise use those dollars to buy US product.

Discouragingly enough, the Kerry campaign response has not addressed the problem, but issued a statement implying that it could be solved by "enforcing trade agreements" and "fighting for jobs here at home" - whatever that means.  Sorry fellas, that just won't make it - not in economics and not in politics.