| STEVE H. HANKE | Steve H. HANKE |
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CONTRIBUTING EDITOR Professor of Applied Economics at the Johns Hopkins University & Columnist at Forbes magazine |
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On Oil Prices |
Just what is pushing prices skyward? Surprisingly, most commentators fail to mention the major role played by the U.S. dollar. Every commodity trader knows that all commodities trade off changes in the value of the greenback. When the value of the dollar falls, the nominal dollar prices of internationally traded commodities, like gold, rice, and oil, must increase because more dollars are required to purchase the same quantity of any commodity. Accordingly, a weak dollar should signal higher commodity prices. And it does.
For example, if the greenback had held its January 2001 value against the euro, oil would have traded at about $83 a barrel on 27 June 2008. This is almost $57 below the price that crude oil was trading at on 27 June 2008. Accordingly, the decline of the dollar’s value accounted for a whopping 51% of the $112 a barrel increase in the price of oil from May 2003 to 27 June 2008.
In addition, global economic activity and the demand for crude oil have been strong since 2003. This demand growth has been accompanied by weaker growth rates in supply-side capacity. In consequence, spare capacity has declined. These smaller margins of safety and the fact that a large share of global oil production occurs in politically unstable regions result in larger risk premiums that contribute to higher oil prices.
To obtain a better grasp of the dynamics of the oil market, consider the market for light sweet crude oil traded on the New York Mercantile Exchange. The accompanying chart shows the prices for futures contracts. These are agreements between buyers and sellers to exchange oil at a later date (August 2008 – December 2010) at a price fixed “today” (either June 5, 6, 13 or 27, 2008). Among other things, it is clear that market participants expect oil prices to remain elevated through 2010.
In addition, the chart shows the record jump in crude prices from June 5th to June 6th, the prices one week after the jump, as well as those on the 27th. These four curves contain information that can be used to calculate the term structure of interest rates for oil. These commodity (or “own”) interest rates are presented in the accompanying table. They provide important insights into the workings of oil markets.
Before interpreting the commodity interest rates, it is important to realize that futures markets operate as loan markets for commodities. As such, they operate in a manner that is similar to money markets. When a handler of commodities purchases (sells) a commodity and simultaneously sells (purchases) a futures contract, he is temporarily borrowing (loaning) a commodity. This procedure is much like borrowing money from a bank with the promise to repay the loan in the future. The sales of a futures contract, in conjunction with the purchase of a commodity in the spot market, allows a handler to borrow a commodity now and repay it later. These simultaneous buy-sell transactions are, therefore, implicit commodity loans.
If the price of a commodity for future delivery exceeds the spot (or cash) price, the market is in contango, and the commodity interest rate is negative. A lender of a commodity lacks an incentive to lend to the spot market because the lender would be in effect selling low and buying high. The reverse occurs when the spot price exceeds the futures price and the market is in backwardation. Commodity interest rates are positive. In this case, it pays those who hold commodities to loan them to the spot market.
When the price of oil made its record jump on June 6th, many conjectures were made about the causes. The one that turns out to be the most plausible is the threat made by the Deputy Prime Minister of Israel, Shaul Mofaz. After Mr. Mofaz stated that an Israeli attack against Iran was “unavoidable” if Tehran continued to push forward with its nuclear program, the curve for futures contracts prices shifted up and its shape changed. With the change in shape, the commodity interest rate switched from negative to positive for 2008. In other words, it became profitable to lend oil to the spot market. This occurred because the precautionary demand for oil became elevated as oil users became concerned about a possible Israeli attack on Iran and the adequacy of their inventory levels. After Israeli defense officials rebutted Mr. Mofaz, concerns were dispelled and the commodity interest rates became negative (see June 13th curve) for 2008, indicating a more relaxed precautionary demand and more adequate inventory levels.
Since June 13th, prices have remained elevated and finally pushed through to a new high on June 27th. The news that drove the market was a Libyan threat to cut its oil production in response to the Gas Price Relief for Consumers Act which was passed by the U.S. House of Representatives. If this Act became law, it would allow the U.S. to bring law suits against member states of OPEC, the international oil cartel, for manipulating oil prices.
Although the Libyan threat drove the oil-price curve higher, the commodity interest rates remained negative. Unlike the Israeli threat, the Libyan threat did not alter the loan market for oil, signaling that oil users were not willing to pay a premium to borrow oil and that inventories were adequate.
As long as commodity interest rates are negative, the market signals that inventories for immediate use are adequate. That said, as long as the dollar is weak, oil prices will remain elevated.
