In two previous reports this week, we covered the reasons oil has been marching toward $50/bbl. while the trading specialists in oil believe that the price should be closer to $35 or even lower. At 1.2 trillion bbl in proven worldwide reserves, there certainly is plenty of oil. However, where OPEC producers (the Saudis in particular) had managed oilfield development to assure an excess capacity of at least 5% of world consumption in past years, there now is almost no excess capacity. The world now is consuming 81 million barrels per day, or almost 30 billion barrels per year.
We now believe that geopolitical risks are not the primary reason for the high oil price, and elimination of those risks will not bring that much relief. That will come only if those countries that have the undeveloped reserves decide to devote the financial resources necessary to bring fresh reserves to market. Already, Saudi Arabia has announced that it soon would tap an oilfield that it had not intended to develop for another year or two and these lofty prices are an economic inducement to other countries to do the same. Oilfields that had been tapped out at lower prices are being brought back into production elsewhere, with more expensive extraction methods justified at this level. This will all take time, but there should be a point in the very near term when this news alone will turn the oil market to at least the $40 level. This should be sufficient -- everything else being equal -- to invite a catch-up on the excess-reserves front.
How long will that take? That depends primarily on monetary policy here in the United States. If the higher dollar oil price is watered down by a higher dollar gold price, which is happening now with gold jumping to $413 today, there would be less incentive for the world oil industry to tap into reserves. The reason oil went to $12 from $3 in 1973 was the recognition by Aramco that gold`s rise to $140/oz. from $35/oz. had led to a quadrupling of commodity prices and they were losing out at the $3 price, which had been steady in its relationship to gold since the Bretton Woods agreement of 1944.
Fed Chairman Alan Greenspan - who has a lifelong appreciation of gold as the primary information signal on inflation - should have persuaded President Clinton that monetary policy should be used to stabilize gold at $350 when it came through that range in early 1997 on its way to a deflated $255 in 2001. However, Greenspan looked the other way, and presided over the consequences of the worldwide deflation, given the fact that so much of the world linked their currencies to the dollar or at least keyed off the dollar. Oil was driven down to $10/bbl. and an oil industry that had been counting on oil over $20 to justify capital expenditures for further exploration and development pulled in its horns and stopped spending. To this day, the industry and those who provide its finances, are reluctant to make long-term commitments. They do not know how soon and how far oil will fall in the next cycle, should this "bubble" burst in a recessionary slide of global proportions.
Gold`s rise to today`s $413 from $380 during the past several months is coincident with the Fed`s decisions at the last two FOMC meetings to raise the federal funds rate from 1% to 1.5%, in order to head off what it believed to be an incipient inflation. We questioned the reasoning because we were worried that the mechanism is designed to slow the economy, not to prevent inflation. To the extent a higher funds rate would supply less liquidity to the banking system, it also would cause the business community to demand less liquidity in what they would perceive as a weakened economy. I posited that an ever-higher funds rate might be accompanied by a rising gold price, a vicious cycle that would not end until Greenspan & Co. found the "natural" interest rate they say would be sufficient to stop inflation without damaging economic growth. There is, as you can see, an intellectual inconsistency here, which is why Greenspan cannot say when that natural rate will be reached, or how we will know how long it should remain there when it is reached.
Treasury Secretary John Snow, who has the misfortune of not having any grounding in monetary theory, has been showing up on the financial news networks to assure everyone that the economy is still strong and that it will continue to expand. With President Bush`s re-election at stake and the GOP convention in New York City next week, there is every effort being made to put the best face on the statistics being churned out on the state of the economy. To be sure, the economy is still in an expansion mode, benefiting from the tax structure on capital put in place last year. The economists who say the 2003 tax cuts did give the economy a boost, but have run out of steam do not understand that when an efficient tax structure is put in place it does not stop inviting fresh growth. Most of the recent disconnect comes from the difference between the Establishment Survey on job growth, which has been so-so, and the Household Survey, which has been robust. The Household Survey is the more accurate of the two because the bulk of the expansion has been the result of the more favorable capital tax structure, which favors entrepreneurs and business start-ups whose jobs don`t make the Establishment Survey. Senator Kerry and his team are barking up the wrong tree on this issue and cannot benefit from it at the polls.
In the aggregate, the electorate knows how many people are employed without reading the papers. While individuals may answer pollsters with concern about jobs, having heard the Democratic pitch on political ads, when they do vote, those concerns are outweighed by reality. There is a genuine concern about the availability of "better jobs" with higher wages and health benefits, issues that flow from the new "globalization paradigm" that I addressed earlier this year, but these concerns cut both ways when neither political party is presenting the electorate with practical ideas on how to address them.
I will be writing a second installment on the Presidential race next week after sizing up the realities of the GOP convention, but this report is only meant to assess the cross-currents in the financial and commodity markets. At this point they suggest slightly weaker economic growth during the coming months, but concerns that if gold continues to misbehave, the Fed soon will face inflation statistics that will lead to further errors in trying to stamp out rising prices with ever higher interest rates and even weaker economic growth.