Tuesday, June 10, 2008

Oil: inflation meets tight supply

Gazprom's prediction of $250 oil came right on time for today's post topic: the factors behind behind steadily rising oil prices.

Last month, as oil moved up to $120 a barrel, we offered a wrap-up (with help from Jim Rogers, Bill Powers, and Matthew Simmons) of some of the factors fueling the nine-year uptrend in oil prices.

Now that volatility in the crude oil market is increasing, with large daily price moves quickly becoming the norm, many traders and market watchers are wondering if we've reached a top in oil prices.

Still, others wonder if prices can continue to surge higher on the growing realization that world oil production may in fact be peaking.

Which brings us to our latest update of the oil discussion. Is the current oil price a reflection of increased speculation, inflation, a weak dollar, or a function of supply and demand?

Paul van Eeden recently addressed these points in a recent BNN tv appearance and in an article entitled, "Sue OPEC".

According to Paul, the recent run up in oil prices over the thirty-some years is largely a function of increased money supply (by the Fed and other central banks) and the ensuing inflation that has taken place over that time frame.

He notes that supply and demand fundamentals have certainly played a key role in driving the price of crude oil, but that the vast majority of this longer-term increase in oil prices is simply a matter of the dollar price of crude oil catching up with the ongoing expansion of money supply (inflation).

Watch as Paul tries to explain this point to the CNBC shills, who try to deflect van Eeden's explanation with smug retorts and 3-on-1 questioning tactics. Sorry kids, no dice. This was like watching a bunch of bush-leaguers trying to pitch to Mickey Mantle.

Now just about every article I read seems to offer the view that high oil prices are "contributing to global inflation". This is incorrect. High oil prices, as Paul explains, are largely a reflection of US and global monetary inflation. They are an effect of inflation, rather than the cause.

This is true not just for oil, but for many commodities where limited supplies are met by rising demand and a torrent of fiat paper money chasing scarce goods.

As Adam Hamilton explains in, "Money Inflation":

"Today something like 2/3rds of the world’s population is starting to strive to live and consume like we blessed few do in the first world. Yet the world’s commodities-producing infrastructure was never designed to cope with such immense and fast-growing demand. It will catch up eventually, but prices will have to rise and stay really high for a long time to entice enough new capacity online to supply increased consumption.

So even if we were on a gold standard with no fiat-paper inflation whatsoever, commodities prices would still have to rise tremendously. But to have such a fundamental secular bull coincide with massive monetary inflation is incredible. Relatively more dollars bidding on relatively fewer already-fundamentally-scarce commodities is going to seriously amplify these bulls."

Check out Hamilton's article for a great, easy-to-understand explanation of monetary inflation and the fundamentals driving the bull market in commodities. Between Hamilton's and van Eeden's articles, you'll get an informative look at some of the true reasons behind rising oil and commodity prices.

Remember: Inflation + tight supplies & rising demand = higher prices.