West Texas Intermediate closed today above $115/barrel. Does that reflect changes in the fundamentals of world supply and demand? My answer is no.
Let me acknowledge first that there has been some interesting news about world oil supplies.
Nate Hagens noted that, although global oil production has stagnated over the last several years, the January 2008 data finally show a new all-time high in terms of the quantity produced worldwide.
Phil Hart had an informative graphic showing how the stagnant oil production for 2007 represented a balance in which gains in production in some countries were just about matched by lost production from others.
And there were some important additional new developments just this week. On the positive side, Brazil announced the possibility of enormous new oil reserves. And for the pessimists, Russian oil production, whose increase has been a critical factor in world oil supplies up to this point, fell 1% in 2008:Q1.
Both of these stories are potentially huge developments. If both Russian and Saudi production have in fact peaked, the global peak cannot be far off, even if the Brazilian find is borne out. But I nevertheless am not persuaded that any of these news items is the primary explanation for the recent highs in oil prices.
The reason is that we’re seeing similar increases since the start of the year in the price of virtually every storable commodity. The 12% increase in oil prices this year is in fact just the median for the group of 15 commodities graphed below. It seems to me we should be looking for a single explanation behind the common behavior of the group, rather than try to develop a separate theory for aluminum, barley, coffee, cocoa, copper, corn, cotton, gold, lead, oats, oil, silver, tin, and wheat.
You can’t attribute much more than half of this increase in commodity prices to the decline in the value of the dollar. The dollar price of a euro (the bold red line in the graph above) is up only 7% for the year, which is less than the price increase for all but 3 of the 15 commodities shown. Another way to make that point is to recalculate the above graph in terms of the price of the commodities in euros rather than in dollars, as is done below. We’re seeing significant relative price changes, not simple depreciation of the dollar.
I also find it implausible to attribute the commodity price increase to a surge in demand. The economic news over the last three months has been very convincing that output is slowing, not accelerating.
Instead I believe that the price of oil, like the price of all the other storable commodities, and for that matter the dollar cost of a euro, is primarily responding to the Fed’s decision to move the real interest rate strongly into negative territory.
But once again the Fed has a golden opportunity to prove me wrong. Fed funds futures prices currently reflect an expectation that the Fed will make one more cut to 2% at the meeting at the end of this month, and then stay there. Here’s a prediction for you. If the Fed surprises the markets by holding steady at 2.25%, all those commodities will begin to crash within hours of the news.
If I’m wrong, well, the Fed can go ahead and opt for an intermeeting cut the following week, and I promise to quit carping about the havoc they’re causing.
What do you say, Ben? Do we have a deal?