Energy and Money Part I: Too Little Oil or Too Much Money?

Inflation is not only determined by the supply of goods available relative to the supply of money to buy them, but also the demand for the currency in which goods are priced relative to the supply of that currency. It can be hard to tell which factor is primarily driving prices.


Sunday morning. The air is crisp. The floor of the woods around my home is orange and red with a thick bed of sweet brown pine needles. A cord of split firewood tumbles out of Jimmy's dump truck into a heap at the end of the driveway. This is the easy wood. The rest is from trees cut down from my neighbor's woods. Six logs take 20 minutes to split by hand with an axe, wedge and sledge. That was yesterday. Here in New England we call energy used in this ritual "burning it twice." All the wood will burn in the fireplace in the living room and in the antique wood stove in the family room, and the wood stove in my wife's studio beside our house where wood is the only source of heat.

One 100 lb. wheelbarrow load rolls down the gravel road to the wood shed. Stack it. Then another. Then another. One cord of wood weighs about 2,000 lbs. Takes 20 round trips, 15 minutes each. Gives me plenty of time to think back on Alan Greenspan's tranquilizing speech on oil and energy back in October 2004.

The price for a barrel of oil had increased from $25 to $45 over the previous year when he made those comments, clearly intended to calm markets that were becoming increasingly alarmed by the steady price rise. He said that prices were due to moderate and decline over time. A year and half later oil prices are nearly 40% higher.

Greenspan's speech is a well written, academic survey of the history of oil prices over the past century. In it, he points out that experts have cried wolf along the lines of "We're running out of oil!" several times in the past. We didn't run out then and we aren't about to now either, he says, pointing out that the oil industry has suffered price volatility for over 100 years, especially in the early days. Periods of high oil prices driven by supply interruptions and demand spikes have been a standard feature of the oil price landscape since the days of Standard Oil.

Greenspan acknowledges that short-term geopolitical challenges pose serious risks of supply disruptions, and that rising demand from China and India contributes significantly to current capacity shortages and thus price volatility. But, he concludes, supply and demand will reach a harmonious balance and stable prices shall return, just as they always have. Market forces will see to it. The feel-good ending to the story: "If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out. Indeed, oil replaced coal despite still vast untapped reserves of coal, and coal displaced wood without denuding our forest lands."

I enjoy a utopian, free market purist's interpretation of energy price history as much as the next guy, but Greenspan misses at least two important lessons of energy history. In Part I, I'll talk about the money supply factor he does not bring up, for obvious reasons. Part II covers explains that his key assertion that "oil will eventually be overtaken by less-costly alternatives"
can't possibly be true unless the laws of thermodynamics are repealed.



Greenspan claims that changes in the balance of oil supply and demand are causing the price of oil to rise. The defining characteristic of oil prices in the past several years has been a steep rise from around $10 per barrel in 1999 to over $72 today. Not to put too fine a point on it, that's a 620% increase. Greenspan claims that the relentless rise in prices is largely the result of supply disruptions coincident with rising demand in China and India and factors he alludes to with typical political circumspection as "geopolitical challenges."

All manner of oil supply interruptions—hurricanes, strikes, revolutions, militant attacks—have been going on for decades without causing the price of oil to relentlessly rise as it has for the past seven years with only one significant pullback in 2002. It used to be—ever since OPEC's supply-induced price shock in the 1970s—that events that disrupted the oil supply temporarily caused oil prices to spike, then decline nearly as rapidly. For example, as you can see in the chart above, in 1990 during the start of Gulf War oil prices jumped at the beginning of the conflict then dropped back down a few months later.

An increase in demand from China and India combined with war in the Middle East, nationalization of energy supplies in Latin America and other geopolitical issues are plausible explanations for a steady rise if not for the parallel rise in the price of everything else, regardless of supply. For example, there have been neither silver supply nor demand shocks yet the price increased in line with the price of oil from 2003 to 2004, and has been playing catch-up with the price of oil from 2005 to date. This analysis by a publication in China concludes that high oil prices arise not from their demand for oil but U.S. printing too much money.




Another place to look for correlation between sustained oil price increases and price drivers is the dollar money supply.





Money stock, as measured by Money at Zero Maturity (MZM) -- a more reliable measure of money in circulation than M1, M2, and the now defunct M3 -- has grown in four distinct periods since 1995. (A) is the period leading up to the stock market bubble, (B) the period of the stock market bubble when the market was producing its own money, (C) the period when the Fed flooded the system with liquidity in response to the collapse of the stock market bubble, and (D) the period of Fed "tightening" during which foreign central bank purchases of U.S. treasury and agency debt kept long term rates low, allowing the housing bubble to form and grow, and commodity prices especially, increase by in some cases several hundred percent.

If the rising oil price were largely a commodity supply and demand issue, then oil and other petroleum-based commodities would have also increased in price by a similar margin when priced in other currencies. But these commodities did not increase in price nearly as much when priced in currencies other than the dollar, at least not at first. If you live in Europe, between 2002 and Greenspan's piece in 2004, you experienced an oil price increase from EU$22 to EU$35 when the dollar price of oil in the U.S. increased from US$20 to $45, a 63% vs. 125% gain. Since 2004, however, oil along with all other commodities have been rising in terms of other currencies besides the dollar. The most logical explanation is that all currencies have been debased in unison, but this is hard to measure. One indicator is the Dabchick Gold Index.


This index is intended to show how gold is valued throughout the world independently of the value of any country's individual currency. While the gold price increase from 2001 until November 2005 was greater in dollars than in other currencies, since November 2005 the price rise has been more or less the same in all currencies.




While it's hard to separate money supply and demand from commodity supply and demand factors, a continuously rising price of oil along with other commodities over an extended period of money growth implies that expensive oil may be due at least as much to an excess of money as to an tight oil supply. Of course, it's not a central banker's job to tell you that. It's his job to tell you that everything's going to work out just fine.

No one can say for sure how much the rise in the prices of oil and other commodities are related to the money supply, to the risk premium added by the world's first "pre-emptive war," to nationalization of oil and gas production in Latin American countries. One thing is certain: if central banks significantly reduce the money supply to contain the rise in assets prices, signficant deflationary forces are likely to be released that the Fed may find difficult to control. This is why I believe the Fed's stated effort to withdraw liquidity will either not be followed by serious action to achieve it, or will be followed by an even more extreme reflation campaign than followed the brief period of deflation that resulted from the collapse of the stock market bubble in 2000.

Cutting and hauling wood is a lot of work. The switch to coal from wood not only made life easier, but required less energy to get to the fuel to where it's burned. The switch to oil from coal made that even easier; oil doesn't have to be chopped up and hauled around; vast quantities can be conveyed cheaply through pipes. In Part II, I question Greenspan's assertion that "...oil will eventually be overtaken by less costly alternatives..." In fact, the switch to oil alternatives will be a step backwards to an era when you had to expend a lot of energy just to get the fuel to the point where you can burn it.


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