David R. Henderson  

Gold and Oil Prices

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Oil prices aren't high right now. In fact, they are unusually low. Gasoline prices would have to rise by another $0.65 to $0.75 per gallon from where they are now just to be "normal". And, because gasoline prices are low right now, it is very likely that they are going to go up more--perhaps a lot more.
This is from Louis Woodhill, "Gasoline Prices are Not Rising, The Dollar is Falling," on Forbes.com, Feb. 22. A friend on Facebook posted this article after I had linked to my recent post on oil prices.

Woodhill goes on to argue that the price of oil in terms of gold is low. In other words, he takes the price of oil in gold as the relevant price rather than the price of oil in dollars.

But let's say for a minute that Woodhill is right and that we should judge the price of oil in gold. Let's look at some recent history. On Feb. 3, the price of oil was $97.84 and on Feb. 24, just after he wrote, it had risen to $109.77. That's a 12% increase. Now if what's really matters is the price of oil in gold, then there shouldn't have been much of a change. So let's look at the price of gold over that same time. On Feb. 3 it was $1737.90. On Feb. 24, it was $1775.10. That's a 2% increase. That implies, using basic arithmetic, a 10% increase in the price of oil in terms of gold.

So the apparent constancy that Woodhill thinks should exist between gold and oil prices does not exist.

Furthermore, if what's really going on, as the headline says, is that the dollar is falling, then other prices besides gold prices should have risen in terms of the dollar. In other words, the inflation rate should be relatively high. The inflation rate for February is not due out until March 16. But I'm quite confident that it won't show even a 1% increase in a month (which would be 12% on an annual basis.)

An economics version of Occam's Razor applies here. When there are specific factors in a particular market that should be expected to affect prices in that market, look at those factors first before looking at other factors that should be expected to affect prices overall, especially when prices overall are not changing much.

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COMMENTS (16 to date)
RPLong writes:

What about the argument that the most important price inflation is occurring in markets that are specifically excluded from the inflation rate (i.e. food and energy)?

The majority of my home's expenses go to food, and I don't think there are many who would dispute that food price inflation has hit us pretty hard. That is much more than 1% inflation, at least at the household level...

CKE writes:

Oil price rises could be linked to a falling dollar without a rise in general inflation (at least a currently detectable rise).

Oil prices will be quicker to reflect inflation expectations than general prices, and the time lag could be substantial (months or years not days or weeks). Another aspect to this is that inflation expectations may bounce around and this volitity could show up in oil prices without ever being reflected in overall prices.

Furthermore, since prices do not change at the same speed, inflation will drive changes in relative prices (at least temporarily where temporarily could be many months or even years). Relative price shifts can constrain the movement of other prices via market forces.

The problem is that you cannot separate devaluation driven changes from market driven changes. All you can see is the price. You cannot know in real time how much of a change is due to expectations about the dollar and how much due to market forces.

Ken B writes:

'Basic arithmetic' works as snark (which I always admire) but isn't quite right. 10% is right but 12 - 2 is wrong.

IVV writes:

That's a recent gold-oil ratio of 16.2. Oddly, that's not particularly different from the long-term trend; the clear signals are usually under 10 (gold is cheap relative to oil) or over 20 (oil is cheap).

Ultimately, the story that the dollar is dropping in value appears to have merit. It may be that these other components are simly less valuable?

David R. Henderson writes:

Food and energy are in the CPI. See the article in the Encyclopedia on this. In fact, food is 15.6% of the CPI. Gasoline is 3.1%. And other energy shows up in other parts of the CPI. The CPI that is reported every month includes food and energy. And, of course, the BLS also reports the CPI excluding those two things.
@Ken B,
If I had subtracted 2 from 12, you would have been right to criticize. But I didn’t. Basic arithmetic includes multiplication and division. I used division.

David R. Henderson writes:

Oops. I forgot to provide the link to the article on the CPI. Here it is:

MG writes:

It's amazing what not having GWB in the WH has done for the higher geo politic-economic content behind the who/what is to blame for higher oil/gas prices. (No more blaming the President's action or inaction, which need not adduce affiliation heuristics.) I suggest this intersting article below, which points to several factors, and which may come much closer to the answering the question (in this case, the price of gasoline).


I think there is a weak dollar effect at play, but it can not be as high as the sources cited therein. The dollar price of tradeable commodities under stable suppply may be a better control than CPI, in my opinion.

Joe Cushing writes:

My protein powder went up 12% in less than a year. So did my aquarium salt. I don't think you can look at gold and oil over one month to make your comparison. There is not enough data there.

RPLong writes:

Hmm. Then I wonder why the drastic increases in food prices don't impact the CPI more than they do.

Shayne Cook writes:

A thanks to MG for the link to the american.com article. It's quite relevant.

But there is another not-often-mentioned driver of petroleum/gasoline prices - the global commodity nature of petroleum. A variety of studies have shown that in any given market, it is the fastest growing economies that set prices for global commodities, not necessarily the largest consumer of those commodities. That may seem counter-intuitive until one considers that rapid growth provides the means for an economy to "out bid" other economies for the raw materials required to sustain rapid growth.

Lots of folks are used to thinking that because the U.S. has the largest single-country economy - and is thereby the largest consumer of globally traded commodities - that it is also the "price-setter" in all markets. Not so. The U.S. economy is still the largest, both in terms of production and consumption, but not by an overwhelming margin anymore. The U.S. economy represents well under 25% of global GDP, and that percentage is dropping. And the U.S. is certainly not in the league of extraordinarily high growth rate economies.

David R. Henderson writes:

@Shayne Cook,
Good point, but it can be stated much more straightforwardly. Oil is sold in a world market. Therefore the price is set by world demand and world supply. A given shift in demand by any demander, no matter where, will have approximately the same effect on the price of oil as the same size shift from any other demander. Why just “approximately.? Differences in transportation costs.

MG writes:


What you all are referring to is very real, and could even be seen as a "tyranny of demand" (that it is the last marginal user who sets the price). Clearly, these "last", marginal consumers of oil in growing economies deem it more "productive" at those ever increasing prices (especially if government subsidies are factored in) than the stabler users deem it less "productive" -- so total demand keeps growing. So "all" we need to do is shake up the supply curve. For oil, this may just mean recognizing that oil need not be produced from only obvious/convenient sources. This is hardly a shake-up, although I believe that non-market forces (acting over more than a couple of decades by now) have kept this supply suppressed for so long, that by now they could have made a difference by now, and still may.

David brings up the issue of transportation costs (geographic arbitrage), and this is an area where a real shake up can happen. We live in a world where we have tended to assume away transporation costs. Even for oil, they are smallish enough to make it trade as a global commodity. Natural gas is an entirely different animal. I was listening to a panel on energy at http://www.manhattan-institute.org/ (under videos), and came across mesmerized by the implications of natural gas selling (as I recall) at both $2 and at $10+ (units left for clarity, but they are supposed to be in common energy factors). The panelist see a great potential for global convergence, given a commitment to crash the efficiency of its transportation and the relative value of a currency exchange rate (in this case the CHN/USD). The same I think will happen in bulk minerals, for which China Max capacity vessels may become the norm. Once you unleash the single-mindedness (unsqueemishness) of the Chinese production machine both as producers (in and in other people's backyards) and as base level demand for transporation, Julian Simon may yet make another triumphant return.

Ken B writes:

I think your remark about basic arithmetic was meant as a slight to the reporter. I have no doubt you know and used the correct math, but I think your wording was a bit tendentious, clearly suggesting he couldn't even subtract 2 from 12 properly. Else why comment on it?

Shayne Cook writes:

@David R. Henderson
I think your global-demand/global-supply is essentially correct, but also a misleading oversimplification. At worst it hints that prices are somehow determined by on costs-of-production/delivery. That is the worst fallacy non-economists can rely upon. Prices are determined by demand and demand alone. Costs of production/delivery only determine availability, not price.

A couple of points ...
1.) The currently high spot and futures oil prices (WTI and Brent North Sea) are quoted at the well-head - transportation is not factored. See the EIA graphic referred to at the american.com article that MG referenced to see how "at the well-head" oil price vs. transportation/refining/etc. costs affects U.S. gasoline price.
2.) Lots of folks (within and outside the U.S) seem to think that U.S. demand is inordinately high - the U.S. consumer penchant for SUVs, wasteful use, etc., etc. - and that is the proximate cause of high global oil prices. The point of my comment was to disabuse folks of that notion of cause/effect. The U.S. is still the single largest (by quantity) demander, but it is not the price-setter by virtue of that characteristic. The fastest growing economies are the price setters - bidding up the price at the well-head, irrespective of where the well-head is located.

To point 2., MG alludes to the "global convergence" pricing phenomena that has yet to take place with natural gas (NG). That "global convergence" of prices has already taken place with petroleum, copper, iron ore and a variety of other commodities. As indicated, NG prices will get to global-convergence status. And the price in the U.S. for NG (currently about $2.20 per Mcf* - at the well-head) will "converge" to a substantially higher level based on global supply/demand characteristics and driven by the fastest growing economies. That is the essence of "global convergence". The limiting factor right now is the lack of availability of NG transportation, not the transportation costs.

* 1 Mcf = One Thousand Cubic Feet.
1 MMcf = One Million Cubic Feet.
1 Tcf = One Trillion Cubic Feet.

David R. Henderson writes:

@Shayne Cook,
Prices are determined by demand and supply, not demand alone.

Shayne Cook writes:

@David R. Henderson

In a supply-constrained market, such as that with global petroleum, Supply, over a broad range of prices, is fixed (maximum - vertical S). An increase or decrease in Demand shifts the demand curve. But since Quantity Demanded (Qd) cannot exceed Supply within the vertical range of prices (Qd = Smax), it is Demand change alone that drives price change.

And, by the way, that occurs completely irrespective of costs of production/transportation.

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