As oil prices in New York rose over $92 per barrel for the first time, I guess it’s understandable that everywhere I turned this morning there was a story on oil that caught my eye. In the first (hat tip: Memeorandum) a group of oil experts agree with me that an attack by the U. S. on Iran is unlikely:
A U.S. military strike against Iran would have dire consequences in petroleum markets, say a variety of oil industry experts, many of whom think the prospect of pandemonium in those markets makes U.S. military action unlikely despite escalating economic sanctions imposed by the Bush administration.
The small amount of excess oil production capacity worldwide would provide an insufficient cushion if armed conflict disrupted supplies, oil experts say, and petroleum prices would skyrocket. Moreover, a wounded or angry Iran could easily retaliate against oil facilities from southern Iraq to the Strait of Hormuz.
The second article that caught my eye was this one from the Financial Times on the link between oil and the dollar:
After a generation on the sidelines, the US dollar has re-emerged as a central issue in the pricing of oil. Since the credit crunch in August, when the dollar has gone down, oil has gone up, by an average ratio of more than five to one. Since August 21, the greenback has declined 4 per cent versus the euro; West Texas Intermediate crude, the global oil benchmark, meanwhile, is up 25 per cent.
Why are commodities traders fixated on the dollar? Like other oil market puzzles, the answer may lie in Saudi Arabia.
With a booming economy and inflation ticking higher, some speculators worry that Riyadh will de-peg its currency from the dollar. And they see such a step as having the effect of re-pricing oil in euros and yen.
That is because if Saudi Arabia de-pegs and does nothing else, it will be sitting on two rapidly depreciating assets: $20,000bn in oil reserves and $800bn in US dollar reserves.
But if it were to diversify its currency reserves or oil pricing regime, then it is almost certain that the dollar would weaken. As a result, oil prices in dollar terms would have to jump to keep oil demand growth from Asia in check. For speculators with this mindset, oil at almost any price looks cheap, especially when the market is pricing in another dollar-weakening Fed cut this month. Speculators do have it right that the US and Saudi business cycles are increasingly out of sync, and that it will become more difficult for Riyadh to maintain its currency peg to the dollar without exacerbating inflation. Inflation has crept higher, from 2.3 per cent in 2006 to an annualised 3.8 per cent this July.
Hat tip: John Burgess
As I read that article it occurred to me that among the things the KSA and China had in common were an interest in oil and large holdings of dollars. James Hamilton in an excellent post (lots of interesting charts and graphs) on the reasons behind the rise in the price of oil rounds the circle:
Total global production may have stagnated, but demand has not. Demand for oil from China has continued on its exponential trend, growing more than 8% in 2006. Whereas Chinese consumption accounted for 3.4% of world demand in 1990, it now represents 8.6%. And if Chinese consumption has increased with global production constant, that means oil use by all the rest of us must decrease. For example, U.S. petroleum consumption fell 200,000 b/d during 2006. And what persuaded Americans to do that? Higher oil prices.
James’s main point is that prices are rising because supply is static while demand is rising. To that I’d add that with the dollar falling high demand allows the Saudis to raise prices so that their oil continues to maintain its value in real terms and that China is key in both the high demand for oil and the falling dollar.
Does that sound to you like a positive feedback loop? It certainly does to me. Let’s remember that the consequence of an out-of-control condition of positive feedback is a collapse of the system.