In January 1972, Canadian economist Robert Mundell gave a talk in Geneva a few weeks after President Nixon pronounced the Smithsonian Agreement “the most important monetary agreement in the history of the world.” (The IMF float of most currencies tied to an inconvertible dollar failed, ending in February 1973 as all currencies floated.) Having predicted in September 1967 that this would happen, Mundell in 1972 then observed the dollar/gold price at $70, up from $35 six months earlier, and said “We will soon see a dramatic rise in the price of oil and thence all commodities.” He actually was off the mark a bit, as other commodities climbed before oil did. The reason, which Mundell could not foresee, was that the Organization of Petroleum Exporting Countries (OPEC) continued to sell oil for devalued dollars until gold settled at around $140/oz. in the summer of 1973 after running as high as $200/oz. in earlier months. At that point, OPEC announced a quadrupling of the oil price to $8/bbl. and production cutbacks to sustain it. Democrats as well as Republicans denounced “the Arabs” for this treachery. Because all Keynesians and monetarists supported the break with gold, Mundell was the only one around who could say “I told you so,” but nobody heard him except Art Laffer, his protégé. I had just joined the editorial page of the WSJournal and heard of Mundell and his prediction from Laffer, who was teaching me economics by telephone.
The history is worth noting for several reasons. The most important is to remind ourselves of the stubbornness of both the Political Establishment and its subordinate Economic Establishment. Here we are 27 years later, and history continues to record that “the Arabs” caused the oil price rise. Nobel Prizes in economics have been handed out to each of the famous academics who helped persuade Nixon to float the dollar, but Mundell remains a relative pariah in his profession. We note the Sunday New York Times of November 22 finally reporting that deflation MAY BE COMING. “If Deflation Hits, It’s a Whole New Game,” by Reed Abelson, who does not understand his subject. The story quotes and pictures A. Gary Shilling. Why? Because Shilling, who may have the worst forecasting record of the last 30 years, has written a book, Deflation, which has no redeeming social value.
The other important reason for noting the history is that “black gold” again has followed the yellow metal, this time down in a deflation. We now are two years into the dollar deflation that began in November 1996 as the global demand for dollars began to outstrip the Fed’s willingness to supply them. Gold is down 23% in two years, to $295 from $385, and oil is down 40%, to $12/bbl. from $20, which at least suggests that oil has become undervalued relative to its “normal” relationship with gold. Two of the biggest oil companies in the world, Exxon and Mobil, now are being forced into merger talks in a frantic move to conserve resources with no price relief in sight. It is safe to say that not one board member of either company has a clue that Federal Reserve Chairman Alan Greenspan is the main source of their problem. The only reason some of the independent oil companies that are being wiped out by the Fed understand the correction is that the president of the Independent Petroleum Association of America, George Yates, has been a client of Polyconomics. He writes about our deflation analysis in the current (November 1998) Hart’s Oil and Gas World.
The world oil price eventually will equilibrate with gold, which means the ratio of about 14-to-1 that has held up for most of the century. At $295 gold, this means $21/bbl., but to get from here to there means there has to be a considerable decline in the amount of oil being supplied to the world. This is an extremely painful process in that part of the world put into recession by the Fed’s error. In our own oil patch, a significant volume of production is unprofitable at prices below $12. The posted well-head price of South Louisiana crude is now $9, which equilibrates with $7 FOB Saudi crude. This means at the margin U.S. production will shut down in the process of restoring price equilibrium worldwide -- or there would be a political upheaval somewhere that shuts down entire countries. There are now 20 countries that earn more than a fifth of their hard currency by exporting oil. They are pressing to produce more, not less. The OPEC countries have tried and failed to come to an agreement on lowering production in order to boost prices. One problem is that too much oil is coming out of countries such as Russia that are not members of OPEC and are forced to keep the oil flowing to meet hard-currency demands. At $12/bbl, a gallon of petroleum is worth only 28 cents, which is less than bottled water at wholesale. It was not terribly long ago that the United States produced all the oil and gas it needed. With so much of the rest of the world trying to make a living on commodity production, we now import 57% of our petroleum consumption. Those who make national security arguments in urging oil import fees will be getting louder and louder as more domestic production is shut down.
It is important to note there is plenty of oil in the world. There now is more than a trillion bbl. of proven reserves or enough to last 40 years at current projected rates of global consumption. In case you think your grandchildren will run out of petroleum, forget it. The only reason proven reserves are not at 80 years is that OPEC countries that sit on trillions of barrels of unproven reserves have no incentive to explore for more while they can’t sell what they have in inventory. Global consumption, which averaged 71 million bbl. per day in 1997 is up from 61 million only ten years earlier. Even once China and India get rolling, we will be in no danger of exhausting supply. All the oil ever produced would still not fill half of Lake Tahoe, Nevada, which reminds us about how small people are and how big the Earth.
The oil price will come back toward $20 with or without an increase in the gold price. It would be less painful if the Fed were to begin the process. The NYTimes on Sunday notes how Iraq’s Arab friends have an added incentive to keep sanctions on Baghdad, because the oil price has them all so hungry for dollars. To bank on political explosions in one part of the world to avoid bankruptcy in another surely is within the definition of “evil,” if one has anything to say in the matter. Even with all the oil in proven reserves, there is only a small amount of it close enough to the required infrastructure to come back into production in the short term. This is why the price could move up fairly quickly. If producers saw gold moving up, it would indicate oil would not have to fall another dollar before a major shutdown occurred over war. Inventories would be accumulated to get the lowest prices available and this alone would push up wellhead postings around the world.
We hear that Time magazine is thinking of making Alan Greenspan its “Man of the Year,” in celebration of his three quarter-point interest-rate cuts. Time, of course, is the official periodical of the Political and Economic Establishment. It would be the last place to note the Arabs did not cause the dollar price of oil to quadruple in 1973 and the last place to note the Fed today is responsible for most of the financial chaos around the globe. This, unfortunately, is the way the world works.