What’s Driving Oil Higher? It’s the Dollar, Stupid!

by: J. S. Kim posted on: May 14, 2008

In this article, I will debunk the many articles that attribute inflation to rising prices and rising oil prices to nefarious OPEC nations that squeeze production and gouge Western nations. With the use of four charts, I can explain most succinctly what is the predominant factor in contributing to rising oil prices.

Just as inflation causes rising prices, and not the other way around, the falling dollar is the greatest single determinant of soaring oil prices, not speculators and not a shortage of supply. Sure, these other factors contribute to rising oil prices and shortage of supplies will certainly drive oil prices even higher in the future, but they are not THE main contributor today despite all the articles to the contrary. That honor goes to the falling dollar. To understand, take a look at the four charts below.

I have plotted the USO [AMEX], the United States Oil Fund, LP against gold, silver, the euro and the U.S. dollar for the last 3 years. The United States Oil Fund, LP (USO) invests in futures contracts for light, sweet crude oil and other types of crude oil, heating oil, gasoline, natural gas and other petroleum-based fuels that are traded on the New York Mercantile Exchange [NYMEX], International Currency Exchange [ICE] Futures or other United States and foreign exchanges, so generally it acts as a very good proxy for the price of crude oil (and gas).

If we look at the USO plotted against fiat currencies, it indeed appears that the price of oil is soaring. The USO has soared about 52% against the Euro in the last 3 years. On any terms, this is quite a hefty rise, but even this hefty increase pales in comparison when we observe the 3-year chart of the USO priced in U.S. dollars.

In U.S. dollars, the USO has soared by more than twice the rate it has against the Euro at 115%. However, because both the Euro and the Dollar are fiat currencies backed by nothing but the full faith and credit of governments, they theoretically can both be debased into worthlessness.

So now let’s price the USO in gold and silver for the past three years. When we do so, a markedly different picture emerges. The USO, over three years, despite having soared by 52% and 115% when respectively priced in Euros and Dollars, has incredibly dropped in value by 11.5% over the same time period when it is priced in gold. This means that oil would actually be cheaper than its price from 3 years ago were we to price its cost in ounces of gold. In other words, if the dollar was on a true gold standard today, nobody would be talking about soaring oil prices.

And what about when priced in terms of silver? If we price the USO in ounces of silver, we see from the below chart that the price of the USO has plunged a monumental 25% in price over the last 3 years.

So what does this tell us? In very simple terms, when goods are priced in stable currencies, their prices remain much more stable as well. When goods are priced in unstable, highly inflated currencies, then their prices soar primarily due to the significant debasement of the currency they are priced in. Furthermore, as I explained in this previous article, the debasement of currency often gives rise to an illusion of wealth creation while in reality, it actually destroys real wealth.

Though many others wish to confuse you with complex algorithms that include 50 different variables that determine why prices rise, in our current environment, dollar debasement is the top contributor. Yes, I do understand that it REALLY is not that simple, as the dollar has risen in recent weeks and so has oil, but you get my point, right? I’m not here to discuss other factors such as the spreads between futures and spot prices which move markets and what not, but just to discuss a very important point that I never see discussed in the mainstream media.

So if oil had been priced in Euros for the past 3 years, analysts would only now begin to start discussing rising oil prices. And if the world had been forced to keep large reserves of silver and gold for the past 3 years to pay for their oil, well, the only discussion that would be happening today would be within the meeting rooms of OPEC as they tried to figure out how to increase diminishing profit margins from falling oil prices.

Of course, one could argue that were oil priced in gold from 1980 to 2001, oil would have soared in price as gold spent 21 years in a bear market during those years. However, were the U.S. dollar backed by a true gold standard during these years, the price of gold would not have plummeted either (this analysis is much too complex for the scope of this short article). So when people say that oil is heading towards $150 to $200 a barrel, this prediction, though they will never admit it, is primarily based upon the untenable situation of the dollar, not the dwindling supply of oil as they state.

In terms of gold bullion, the price of oil will most likely only get cheaper or remain stable in the next few years. And due to continuing debasement of the dollar, we are highly unlikely to see oil prices retreat past $80 a barrel anytime in the foreseeable future.

I have always found many stories reported in the media to be humorous. For example, this past month, recent IMF officials stated that rising prices of food and oil are creating raging inflation rates worldwide that are quite worrisome. This is comparable to blaming a destroyed orange crop in Florida for creating frigid temperatures instead of correctly attributing the frigid temperatures to the destruction of the orange crop.

Yesterday, a news article out of Washington stated the following: “US President George W Bush will discuss rising oil prices and subsequent effects on global economies with Saudi Arabia’s King Abdullah later this week.” The report further stated that “A White House spokeswoman also said that Bush would raise the issue of how high oil prices are draining the world economy.” While the debasement of the dollar is not the only contributing factor to rising oil prices, of all the factors, including dwindling supply, it is the largest singular contributor.

So again to use my analogy of the orange crops, singling out supply and production rates as being the most problematic factors in rising oil prices would be similar to discovering that 5% of all oranges destroyed by severe weather were also infested by bugs and then calling on a pesticide manufacturer to develop better pesticides as the solution. Of course, the best pesticides in the world still wouldn’t have saved the other 95% of oranges from being destroyed. In conclusion all the negotiation in the world won’t stop rising oil prices. Only a strong currency will stabilize prices and effectively moderate rates of inflation.