Thursday, March 13, 2008

A look a Oil Politics.

Ronald Bailey, the science writer at Reason, is someone I always enjoy reading. And I find that a good chunk of the time I learn something new. He has a good piece on the current oil situation. Americans are finding themselves facing $4 per gallon gasoline. A fill-up of a not quite empty compact car today cost us $39.00.

Bailey notes that consumption of oil has not been increasing as fast the supply has. You would think that would drive down the price. But there are other factors involved here. And two that he mentions are particularly important. One is rather obvious, that is the destruction of the value of the US dollar. The other less so. Let’s discuss the former one first.

Bailey notes that the US currency has fallen 30% against foreign currencies since 2002. This certainly is driving a lot of the problem. I don’t actually mind. I stopped savings in US dollars sometime ago. I don’t have much but what I have has been increasing due to the complete failure of the Bush administration in fiscal/monetary matters. At least that is one thing I can be thankful to King George for. When I converted my savings into Euros it cost $1.18 per Euro. At this time, when I covert back, I get around $1.55. That is just over a 30% increase in value in just three years. A second account in another currency increased by about 50% since I opened it six years ago.

But Bush decimation of the U.S. dollar is not the entire story by any means.

Bailey does note that political instability is involved but he also notes it is much reduced from what it was a few months ago. Bush’s saber rattling against Iran hasn’t done much to help -- but Bush rarely does anything that actually helps. He is like the proverbial bull in a China shop -- an utterly destructive force.

There is something interesting to consider about the connection between political instability and oil. First, contrary to the ravings of the Loony Left most major oil production is a socialist enterprise. National governments control oil in most countries. And where this is the case there is inherent political instability. Government, like Bush, tends to be be destructive. It is inherently irresponsible. Government is an entity which exists by force. It doesn’t have to supply a need or fulfil a function to stay in place. It can use guns -- and does.

It also tends to be a collective decision making process with large numbers of anonymous bureaucrats and petty officials having vast amounts of power. This collective nature of government means that no one individual tends to feel responsible for what the entire organization does. It is like a mob mentality where the individual players all blame everyone else there for the actions that take place. This lack of individual responsibility means it will act badly.

All the economic incentives of government are perverse. Governments don’t have to satisfy consumer in order to “make a profit”. They don’t sell a product but force consumers to buy products at the point of the taxman’s gun. But this is not necessarily true everywhere. As bad as that is, it is worse when government doesn’t have to rely on taxes to survive.

The Saudi kingdom does not need taxes. Neither does Chavez in Venezuela. The reason is their oil revenue. Oil producing governments are more totalitarian because they don’t need to encourage private production in order to finance themselves. I think this is one reason we have seen Putin pushing Russia in a more totalitarian direction as oil prices went up -- after he basically nationalized oil production again. When governments don’t have to rely on private production to finance themselves they can act in ways that are economically destructive, ie, like a bunch of fascists.

This is one reason the desire by well-meaning, but addled brained socialist to nationalize oil industries around the world is entirely destructive to all freedom where this happens. Destroying the link between government consumption and the private economy frees the government to act in any destructive way it wishes.
Canada, the US, etc., produce oil but this production tends to be private and only a small percentage of the entire economy. But if governments in the West nationalized oil production they too would be tempted by the same totalitarian forces. (Other institutional factors would reduce that but not eradicate it.)

The head of OPEC said that, “What’s happening in the oil market is due to the mismanagement of the U.S. economy.” That is true but in two different ways. One is the fall in the price of the dollar, which we have covered already. The second is something Bailey discussed, which I had not given much though to before. I told you I learn something from him regularly.

He notes the number of oil futures in the market have increased by 364 percent since 2003. And he quotes Tim Evans at Citigroup’s Futures Perspective: “We are seeing investment flows into the oil market that don’t have anything to do with the demand and supply of oil.” Bailey explains what this means, “Investors are treating oil as a hedge against inflation and a falling dollar.”

As the U.S. economy turns to crap before our eyes investors are looking for safe places to invest. Historically they have turned to precious metals and those indicators are rising at a monumental speed as well. Gold has gone from $647.75 a year ago to $981,90 today. Silver followed from $12.97 to $20.05 and platinum from $1203 to $2065. Oil is now being seen as a “hard asset” in which to invest to help preserve wealth.

My problem with such investments is that they depend on rising demand and demand can collapse. What do you think will happen with recession in America? The primary demand for gasoline, for most people, is commuting to work. Increase joblessness and fewer people will be filling up at $3.50 a gallon. Demand declines. When U.S. oil regulations created an “oil crisis” in the 70s prices escalated and consumption dropped. Eventually the price of oil collapsed. The demand curve for oil is relatively inelastic over the short term but over the long term that is not the case. You might have to drive to work today but given the right economic incentives you may well move closer to your job so you consume less. The rising price of oil will stimulate long-term solutions to consumption.

Bailey ends with some predictions by Mr. Evans. He says: “I think that this is the riskiest time to be long in crude oil since 1980.” He’s expect the price to drop by 30 percent to 40 percent. And while this heresy among the hard money crowd I personally wouldn’t be surprised to see the same thing happen with gold and silver. Certainly if I had investments in any of those commodities I would be selling out know.

When the world starts buying an asset that is often a good time to bail out.