One Energy Crisis After Another

It wasn’t many weeks ago that it looked like the world oil price would be hitting $60 bbl. I remember hearing Boone Pickens saying it would hit $60 before it would hit $40, and he did come close, but oil has been sliding since and it is now getting close to $40. What I’d like to tell you folks about is why the oil price gyrates as much as it does, because it never shows up in your stories -- although the answer has been around from the days I wrote the energy editorials for The Wall Street Journal in the 1970s, That was during the first big “energy crisis.”

The answer is “gold.” If you can look back that far, you will realize that there never was “an energy shortage” in the United States prior to the long-lines and price controls that followed Aramco’s quadrupling of the world oil price in 1973. Never!! The reason is the 1944 Bretton Woods gold standard that Richard Nixon ended in 1971 -- and all the previous “gold standards” that kept the dollar as good as gold dating back to George Washington and Alexander Hamilton.

You do know it is much more expensive finding and delivering oil to the consumer than it is to deliver other commodities like corn, wheat, coffee, copper, etc. There is plenty of oil in the world we know about. Known reserves are now double what they were 30 years ago, when President Carter was sure we would be out of oil by the end of the 20th century. But the infrastructure to lift it, pipe it, refine it, and market it is extremely costly, and the financial markets will not finance all that expense for another barrel of oil unless they can clearly see the final sales price will yield a positive return on the investment.

The reason there were no shortages prior to the “floating dollar” that we are still living with is that the energy industry knew that if the dollar/price of gold was $35 oz today and would be $35 oz ten years from now, the price of oil at $2.50 bbl today would be in the ballpark of $2.50 ten years from now. The oil market, without having meetings to regulate supply in an attempt to fix the oil price, would automatically operate in a way that always kept a 10% surplus of an oil delivery system ready to go if there was an unexpected disruption… a worker’s strike, a hurricane, a war, tensions in the Middle East that looked like war, etc. There was never, ever any discussion about the United States having a “strategic petroleum reserve” on hand to meet such contingencies. If there was a disruption over here, our private oil companies could easily switch to the buffer supplies over there. The price of delivery might increase by a few cents a barrel, but once the crisis passed everything would go back to normal.

The oil market can no longer operate that way because the price of gold swings around wildly in response to the irregular demand and supply of dollars in the U.S. banking system. This means the price of oil, which had been constant at around $2.50 a barrel for several decades prior to 1971, has also swung around wildly in response to the inflations and deflations. Most recently, gold was $380 oz in 1996 and oil was $26 bbl. Then gold sank to $300 in 1998 and oil went to $10 bbl. The dollar gold price shot up after 9-11, from as low as $255 oz a few months earlier to as high as $350 and soon world oil demand from China and India was putting pressure on supply. But where was that 10% buffer? It had shrunk to 1%, which meant any little terrorist could blow up a pipeline or any surprise hurricane in the Gulf of Mexico could chew up the buffer and prices would shoot up. Sorry, Boone Pickens, you really didn’t understand what was going on when you made your predictions, but that’s how it happened. The energy market will now only invest the smallest amount to assure profitability because it has no idea where the next swing in the price of oil is coming from. The consumer market for oil and oil product must then rely upon “just-in-time delivery” or go to great expense playing the futures market to make sure it has claims on product should a shortage develop.

You have heard of “Just-in-time Delivery,” I’m sure, but not in the oil and gas market. We’ve heard it most from automobile manufacturers, who have been forced to adjust to the inflations and deflations of the floating dollar by keeping the smallest inventory of parts on hand. GM and Ford once could stock all the parts themselves and make the whole car, except perhaps for tires and other distinct add-ons where a separate company had a comparative advantage. Now, they have thousands and thousands of independent parts suppliers competing with each other to get the stuff to the assembly lines with as little time as possible in the automaker's inventory.

Okay, but what do we do about this state of affairs? The price of oil is dropped off to near $40 bbl, with repairs made in the Gulf, workers on strike back to work, warmer weather here, tensions in the Middle East slackening a bit. The 1% buffer can handle a string of good news like this, but you well know oil could be back to $60 or even higher, especially if the price of gold, now $440 or so, resumes its recent climb. Oil producing countries will cut production sooner than sell oil for cheap dollars with dwindling purchasing power.

The answer is simple. Refix the dollar to gold, at a reasonable rate of $400, which is where gold was just a few months ago. Once it is clear that the new Federal Reserve policy is to replicate the old Bretton Woods standard, which worked like a charm until Nixon blew it up (on the advice of his economists), the oil industry will know the price of oil will settle near $30 bbl and stay there. Long-term investments could again be made and the buffer will climb to 2%, then 3%, and in a decade be back where it belongs. No more energy crises in the 21st century.

See what I mean? Why won't we do this? Partly because I have been mostly alone in trying to explain it to the Political Class. That's why I've written this to you, so you might give me a hand.

www.polyconomics.com

10 December 2004

Jude Wanniski is president of Polyconomics, Inc. and author of "The Way the World Works - How Economies Fail and Succeed."