More on Gold/Oil Jude Wanniski October 30, 2004

Memo To: SSU Students
From: Jude Wanniski
Re: Another Look

In Lesson #5 on October 9, I went over the connections between yellow gold and black gold (oil) to show the degree to which Federal Reserve monetary policies have been responsible for the wide fluctuations in the dollar/oil price since President Nixon broke the dollar/gold link in 1971. On October 19, with the high dollar price of oil a global concern, I wrote an article for the English-language website of Al Jazeera, the Islamic network that operates out of Qatar, for the first time offering my analysis to that part of the world. It was, I was told, the most e-mailed article off the site for the next several days. I decided to use it as today's SSU monetary lesson so you will see the idea developed from a slightly different angle.

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Why the price of oil is so high Al Jazeera 10/19/04
by Jude Wanniski

Before the US abandoned the gold standard on 15 August 1971, there had been a traditional relationship between gold and oil: One ounce could be exchanged for 15 barrels.

The relationship had held steady for decades as the US fixed the dollar price of gold at $35 and the world oil price fluctuated narrowly around the $2.50 a barrel mark.

Since 1971, the gold/oil relationship began to vary as the US dollar "floated" on international currency exchanges, but until recently it still moved around that 1-to-15 ratio.

Now, an ounce of gold at $420 (when this essay was written) buys only eight barrels of oil at $52 a barrel (bbl). Around the world, industrial and financial analysts are puzzling over why this has happened.

Does it mean a new, permanent shift in the traditional relationship? Is it the result of a coincidental series of supply interruptions due to hurricanes in the Gulf of Mexico and strikes in Nigeria, compounded by the geopolitical threats in the Middle East?

Is it the sudden demand for energy in the rapidly growing economies of China and India, where two billion people have developed a great thirst for energy? Is the world running out of easy-to-get, cheap oil?

None of these questions lead to satisfactory answers.

During the two world wars, there were even greater demands on oil supplies. There was never any extraordinary price spike because there was always a ready reserve in the oil-producing nations, roughly 10% of world consumption.

With oil consumption now at 80 million barrels per day, that would mean a reserve of 8 million bpd on tap.

But it is clear there may be no world reserve at all. The Saudi oil industry has 275 billion barrels of proven reserves and a production capacity of 10.5 million bpd, but it takes time and capital investment to translate proven reserves into ready reserves.

The Saudi oil ministry has accelerated plans to develop those reserves, but why was that 10% cushion allowed to disappear in the first place?

"Why is the price of oil so high? It is because the US dollar is floating, free of gold or any commodity anchor"

It can't be that the world is really running out of oil. The Club of Rome warned 25 years ago of oil depletion by the end of the 20th century when proven reserves were at 643 billion bbl. Today they are at 1.2 trillion bbl. Yes, China and India are now serious consumers of oil, but they have not yet been explored to any significant degree.

In fact, the world as a whole has not been explored for liquid oil, let alone for heavier oils.

In the entire history of the world oil industry, a total of 4.6 million wells have been drilled, with the US accounting for 3.2 million of those!

Africa is four times the size of the US (minus Alaska), yet in the last eight years there have been only 6,280 wells drilled on the continent while 209,400 have been drilled in the US.

There is undoubtedly as much oil in Africa undiscovered as there has been produced in the history of the world oil industry.

The same can be said for Latin America. As for the Middle East, Saudi Arabia has drilled only 1,000 wells in the past eight years, almost all of them production wells, not exploratory wells.

Iraq, with the second highest total amount of proven reserves - 110 billion bbl - has drilled only 100 wells over that period.

"Oil is of course the most important commodity in the world. For the world oil industry to stop investing in its development for almost three years was a shocking lapse"

Which brings us back to the original question: If there is so much oil in the world, why is the price so high? The answer, simply, is that from 1998 to 2001, the world energy oil industry went on vacation.

New capital investment in the infrastructure required to lift oil out of the ground and get it to the hands of consumers practically stopped dead.

Why did that happen? It was of course because it was not economic to make investments when the price of oil had fallen from $25 bbl, where infrastructure investment could make a profit, to $10 bbl.

At that price, returns on investment would be negative. But why had the oil price fallen so sharply?

The answer can be found by looking back at the price of gold.

In November 1996, gold was at $385 an ounce. By January 2001, it had declined to $265 an ounce. From 1971 to 1973, the quadrupling of gold prices to $140 when the US left the gold standard preceded OPEC's quadrupling of the oil price from $2.50 to $10.

The decline in the gold price from 1996 to 2001 preceded the decline in the world oil price from 1997. Instead of a dollar inflation, the US Federal Reserve - it's de facto central bank - was unwittingly presiding over monetary deflation!

It seems clear in hindsight what happened, but in early 1997 I foresaw what was going to happen and warned both Federal Reserve Chairman Alan Greenspan and the Clinton administration that the decline in the gold price was evidence of the beginnings of deflation, and that we would soon experience a decline in the dollar price of oil and all other commodities.

They waved aside my concerns, but oil and all commodity prices soon began the long slide. At the January 1999 bottom, Texas crude sold at $8 bbl with reports of distress sales in the Rocky Mountain states at $5 bbl.

"The Club of Rome warned 25 years ago of oil depletion by the end of the 20th century when proven reserves were at 643 billion bbl. Today they are at 1.2 trillion bbl"

Oil is of course the most important commodity in the world. For the world oil industry to stop investing in its development for almost three years was a shocking lapse.

It was caused not by the industry, but by the intellectual failures in the US that led former president Nixon to abandon the gold standard and along with it the precious signals that standard supplied in guiding capital investment to where mankind needed it most.

In a speech he delivered on 15 October in Washington, DC, Greenspan tried to calm the financial markets and their anxiety about the impact high oil prices are having on the economy, at home and abroad.

"The signals provided by market prices have eventually resolved even the most seemingly insurmountable difficulties of inadequate domestic supply in the United States," he said.

Eventually!! When the dollar was as good as gold, the signals were instantaneous. This is how the oil industry could consistently supply product at a stable price and earn reasonable returns on its investments.

Chairman Greenspan knows full well the errors that were made on his watch at the Federal Reserve in producing such volatility in the global economy, but suggests things do turn out for the best in the end.

Alas, a lot of blood has been shed and a great many bankruptcies have occurred in the process.

Why is the price of oil so high? It is because the US dollar is floating, free of gold or any commodity anchor. As long as it is, the entire world will be forced to somehow accommodate this wholly unnecessary volatility in energy supply and price.

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You can read the article at the Al Jazeera site at
http://english.aljazeera.net/NR/exeres/0026A2DD-CA5E-4776-B4B4-91933C4F058B.htm