Greenspan's Petroleum Speech Jude Wanniski April 6, 2005

There was nothing we disagree with in Alan Greenspan`s speech Tuesday to the National Petrochemical and Refiners Association Conference in San Antonio. It reads like Economics 101 on the law of supply and demand, and how higher price signals will always direct capital in ways that bring new supply and lower prices. What caught our eye was Greenspan noting that "concerns about potential shortfalls in investment certainly have contributed to current record-high long-term futures prices." If he had just given a speech on why there have been shortfalls in investment despite the price signals, it would have meant something to the markets, which clearly paid little attention to his assurances that oil prices and energy costs are bound to fall. His concluding remark: "We must remember that the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion. Moreover, they stimulate the research and development that will unlock new approaches to energy production and use that we can now only scarcely envision."

The sad fact is that until the Federal Reserve Board that Greenspan chairs can see that its mismanagement of the dollar since 1971 is the cause of high energy prices, dollar prices of oil and gas will not come down except in reaction to economic weakness and a decline in demand. As I`ve explained in previous client letters, the "shortfall in investment" will be permanent as long as the markets have no idea what  the nominal price of a barrel of oil, in dollars, will be over the next several years. And that will not happen unless the dollar is fixed to gold, as it was prior to 1971. The law of supply and demand works fine when there is a shortage of apples or oranges. The capital cost of bringing almost any other commodity to market is low enough that investors will bear the risk of changes in the nominal value of an apple or an orange over a growing season. With oil and gas, the costs of bringing known reserves to market are so high, involving several years of commitment, that investors are justifiably worried of losing their shirts because of the floating dollar. Here is how I put it on December 8 in a memo to energy reporters, "One Energy Crisis After Another:

The reason there were no shortages prior to the "floating dollar" that we are still living with is that the energy industry knew that if the dollar/price of gold was $35 oz today and would be $35 oz ten years from now, the price of oil at $2.50 bbl today would be in the ballpark of $2.50 ten years from now. The oil market, without having meetings to regulate supply in an attempt to fix the oil price, would automatically operate in a way that always kept a 10% surplus of an oil delivery system ready to go if there was an unexpected disruption… a worker`s strike, a hurricane, a war, tensions in the Middle East that looked like war, etc. There was never, ever any discussion about the United States having a "strategic petroleum reserve" on hand to meet such contingencies. If there was a disruption over here, our private oil companies could easily switch to the buffer supplies over there. The price of delivery might increase by a few cents a barrel, but once the crisis passed everything would go back to normal.

The oil market can no longer operate that way because the price of gold swings around wildly in response to the irregular demand and supply of dollars in the U.S. banking system. This means the price of oil, which had been constant at around $2.50 a barrel for several decades prior to 1971, has also swung around wildly in response to the inflations and deflations. Most recently, gold was $380 oz in 1996 and oil was $26 bbl. Then gold sank to $300 in 1998 and oil went to $10 bbl. The dollar gold price shot up after 9-11, from as low as $255 oz a few months earlier to as high as $350 and soon world oil demand from China and India was putting pressure on supply. But where was that 10% buffer? It had shrunk to 1%, which meant any little terrorist could blow up a pipeline or any surprise hurricane in the Gulf of Mexico could chew up the buffer and prices would shoot up… The energy market will now only invest the smallest amount to assure profitability because it has no idea where the next swing in the price of oil is coming from. The consumer market for oil and oil product must then rely upon "just-in-time delivery" or go to great expense playing the futures market to make sure it has claims on product should a shortage develop.

It doesn`t really matter that the Greenspan Fed, by guess or by golly, might behave in a way that keeps the gold price stable over a period of months or even years. Investors were lulled into thinking the relatively narrow swings in gold from 1985 to 1997 showed sufficient stability. Plenty of them lost their shirts in the deflation that followed and are now warier than ever in stepping up with fresh capital – especially being advised by the Greenspan Fed that interest rates will keep rising until it is satisfied it has struck a balance between inflation and unemployment. In the last fifteen months, gold has gyrated from $400 to $426 to $374 to $455 to $412 to $444 and now to $427. How is the energy industry expected to make its billion-dollar bets when it has these kinds of market signals to reckon with?

There is a Bloomberg story today that some of gold`s movement in this period has to do with the IMF`s 3,200 metric tons of gold, about 2% of all gold in public and private hands. It says gold bottomed on Feb. 3 when British Chancellor of the Exchequer Gordon Brown recommended sale of the gold to raise money to cover Third World debt and it has been rising in the last few sessions because of U.S. opposition to such a sale. It really doesn`t matter who owns the gold, though. As a monetary commodity, it is only a signal reflecting the intersection of the demand for dollars and supply of dollars. Gold actually bottomed on Feb. 9, when we believe the market began to realize the "pause" in interest rate hikes was not going to take place. During the transaction process, there would be a small effect, we think, as the gold held at the NY Fed would pass from one shelf to another. When completed, though, the price would go back to where it had been. The monetary movement completely dominates the supply/demand of the bullion. This is why gold never backwardizes, in any currency. Where does gold go from here? As always, that does depend on Econ #101, the supply of liquidity and the demand for it. There are so many variables that it could go either way, but our best guess is to expect it to go higher.