In a speech on June 7 in Atlanta at the International Monetary Conference, Fed chair Ben Bernanke downplayed the U.S. central bank’s role in rising oil and gasoline prices. Inasmuch as I recently testified before a Congressional subcommittee saying that Bernanke’s policies have been (partially) to blame, I want to point out the weaknesses in Bernanke’s attempt to shift the blame. Nobody can know exactly how much the Fed has boosted the pain at the pump, but it’s probably much worse than Bernanke is willing to admit.

The Fall in the US Dollar

As I pointed out in my oral remarks and written testimony, there are two main mechanisms through which Fed policy could be driving up oil prices. The first mechanism is that the Fed’s “quantitative easing” programs have weakened the dollar versus other currencies. Because oil is a fungible, internationally-traded commodity, it has to cost basically the same price in every currency, once we adjust for exchange rates. Therefore, when the dollar falls against other currencies, oil necessarily gets more expensive for Americans than for other people.

Bernanke gave two main responses. First, he claimed that the fall in the dollar is no big deal. As an E&E Daily article^[i] reported:

Federal Reserve Chairman Ben Bernanke yesterday moved to dispel an intensifying GOP claim that his central bank’s monetary policy is partly to blame for the current climb in oil and gas costs.

In a speech at the International Monetary Conference in Atlanta, the Fed chief parried the arguments by “some” who link the central bank’s increase in the monetary supply — and the resulting dip in the dollar’s trade-weighted value — to inflation in the price of commodities such as oil. While the studiously apolitical Bernanke did not mention the GOP by name, Republicans lately have ramped up their rhetoric linking the weak dollar to high pump prices that are squeezing consumers (E&E Daily, May 17).

Noting that oil prices are up 160 percent since February 2009, while the dollar has fallen just 15 percent, Bernanke added that “the dollar’s decline can explain, at most, only a small part of the rise in oil and other commodity prices.”

Now this is an interesting defense, if you think about it. The fall of the dollar against other currencies since the implementation of the Fed’s “rescue” policies can explain 57 cents of the price at the pump, as calculated by the Joint Economic Committee. In other words, if the dollar were currently as strong against other currencies as it was at the announcement of the first round of “quantitative easing,” then oil prices would be lower (quoted in dollars) and gasoline prices would be about 57 cents cheaper per gallon.

Most Americans would agree that 57 cents per gallon is a rather significant impact. Yet Bernanke’s excuse above is to say, “Gasoline prices have gone up a heck of a lot more than 57 cents since I began flooding the world with dollars. So clearly I shouldn’t get all the blame for high gas prices.” As I said above, this is a rather odd defense.

Are the Critics Reversing Cause-and-Effect?

Yet Bernanke has one other card to play: He claims that the dollar is falling against other currencies not (just) because the Fed has injected some $1.6 trillion into the financial sector over the last 36 months, but rather because the trade deficit has mushroomed—largely because of rising oil prices!

In other words, Bernanke is saying that oil prices around the world—regardless of which currency you quote them in—have gone up sharply over the past two years. Since Americans have to import so much oil, this factor causes our trade deficit to widen. And a widening trade deficit means (other things equal) that the dollar falls against other currencies. So, in this way, Bernanke is trying to blame the weak dollar on high oil prices, rather than the other way around (as his GOP critics allege).

The major problem with this prong of Bernanke’s defense is that the Fed could be driving up oil prices directly. In other words, it’s not just some fluke coincidence that oil prices around the world (in any currency) have risen sharply, at the same time the Fed has embarked on an incredible expansion of (what economists call) the monetary base. (For those who are unfamiliar with the scale of the Fed’s actions, look at this chart. It is shocking.)

Why might the Fed’s pumping in of more than a trillion dollars cause oil prices to rise? One answer is that investors the world over are worried about the value of their money. With so much liquid funds sloshing around the financial sector, where should investors put their wealth, to protect it from a possibly collapsing dollar? They don’t want to put it in real estate, obviously, but the stock market is also dubious because the economy is on the ropes.

In this environment, many investors think that a good chunk of their overall portfolio should be in commodities, the idea being, “No matter what happens to the banks and Wall Street, people still need wheat and oil.”

This interpretation is plausible, because commodities in general have soared over the last two years. In other words, it’s not simply oil that’s skyrocketed. Since the crisis first struck in the fall of 2008, for example, gold and silver prices are up 80 percent and 210 percent, respectively. Surely that doesn’t merely reflect the “fundamental” demand going up in India and China—more people giving jewelry as gifts? Surely people are flocking to gold and silver to protect themselves from a possible surge in dollar price-inflation.

Conclusion

Ben Bernanke hasn’t exonerated himself. He simply takes it for granted that commodity prices have nothing to do with monetary policy, when there is plenty of circumstantial evidence—as well as common sense—saying that the two may have an intimate relationship.

In any event, American policymakers besides Ben Bernanke have options to provide immediate relief to motorists. For one thing, they could reduce the 18.4-cent per gallon federal tax on gasoline. More generally, they could expedite the permitting process and allow the development of American energy resources.

I am an economist, not a legal expert. In the present article I won’t comment on whether the individual traders “manipulated” markets in violation of the Commodity Exchange Act. Rather, I will argue that penalizing “manipulation” of markets is actually economically counterproductive. Furthermore, even if these allegations are true, these particular traders had little to do with the huge run-up in oil and gasoline prices in the first half of 2008. As the government’s case itself alleges, the defendants pushed oil prices up and then back down a few weeks later.

The Allegations

As reported by the New York Times:

The suit says that in early 2008 [the defendants] tried to hoard nearly two-thirds of the available supply of a crucial American market for crude oil, then abruptly dumped it and improperly pocketed $50 million.

In the case filed Tuesday, the defendants — James T. Dyer of Australia, Nicholas J. Wildgoose of Rancho Santa Fe, Calif., and three related companies, Parnon Energy of California, Arcadia Petroleum of Britain and Arcadia Energy, a Swiss company — have told regulators they deny they manipulated the market.

The commodities agency says the case involves a complex scheme that relied on the close relationship between physical oil prices and the prices of financial futures, which move in parallel.

In a matter of a few weeks in January 2008, the defendants built up large positions in the oil futures market on exchanges in New York and London, according to the suit….At the same time, they bought millions of barrels of physical crude oil at Cushing, Okla., one of the main delivery sites for West Texas Intermediate, the benchmark for American oil, the suit says. They bought the oil even though they had no commercial need for it, giving the market the impression of a shortage, the complaint says.

At one point they had such a dominant position that they owned about 4.6 million barrels of crude oil, estimating that this represented two-thirds of the seven million barrels of excess oil then available at Cushing, according to lawsuits.

The traders in mid-January cashed out their futures position, and then a few days later began to bet on a decline in oil futures, with Mr. Wildgoose remarking in an e-mail about the “inevitable puking” of their position on an unsuspecting market, the federal lawsuit says.

In one day, Jan. 25, they then dumped most of their holdings of West Texas Intermediate oil, and profited by the drop in futures.

The traders repeated the buying and selling in March 2008, and were preparing to do it again in April but stopped when investigators contacted them for information,the suit says.

What Goes Up, Must Come Down

The most obvious problem with blaming these particular traders for any large moves in the oil market is that they held their position for less than a month. Even if the allegations are perfectly accurate, then the traders began accumulating the physical crude for a few weeks in January, reversed their position in the futures markets (to position themselves to profit from a fall in price), and then dumped most of their physical holdings on January 25. They apparently repeated the process in March, and shied away from trying again in April because of heat from investigators.

The crucial point about the alleged scheme is that it was self-reversing. The strategy worked by (a) buying futures contracts at low prices, (b) hoarding physical oil in order to drive up the futures price, (c) cashing out the futures contracts and even taking a net negative position, and finally (d) driving the futures price back down by dumping the physical oil. In other words, the traders allegedly made money both driving oil prices up and then back down. Since they had more insight into the large swings in inventory to which other traders would react, these particular traders were allegedly able to make money both ways.

Therefore, even if these traders behaved just as the government claims, their actions can’t possibly explain the jump in crude prices from about $92 per barrel in December 2007 to a whopping $134 per barrel (average monthly price) in June 2008. Hoarding and then dumping physical oil—in bursts of a few weeks—at worst can make oil prices more volatile; it can’t drive them systematically higher for months at a time.

If anything, these lawsuits demonstrate just how difficult it would be for speculators to drive up oil prices significantly above the level justified by the “fundamentals,” especially if they wanted to make it a “sure thing.” Even though they apparently gained control of two-thirds of the excess Cushing inventory, these traders only made $50 million from the scheme. That’s a lot more money than I made in 2008, to be sure, but it can hardly explain giant movements in the world price of oil.

Speculators Perform a Useful Function in Markets

As I have explained in previous posts, speculators perform a useful function in markets. To the extent that they correctly anticipate future price movements, they actually dampen the volatility in the spot price. This is obvious: Speculators earn profits when they buy low and sell high (or short-sell high and cover low). So if a commodity such as oil will have a price rise in the near future, speculators start pushing up the price now in anticipation. Conversely, if a commodity is current overvalued (in the sense that it will drop in the near future), then successful speculators start the process right away by selling.

The twist in the current story is that (allegedly) the traders were dabbling in both the physical and futures markets. So it’s true, their “speculative” trades smoothed out prices. However, one could argue that their buying and selling in physical crude actually introduced far more volatility in the spot price than their futures trading softened.

This may seem a pedantic point, but it’s important for people to understand the role of futures markets. To say it in other words: It was not their “speculating” on futures prices that actually caused the volatility in oil prices, but rather their accumulation and then dumping of the physical crude. (Of course, the reason they allegedly acted this way in the physical market, was because it allowed them to earn speculative profits in the futures market.)

Now for the tough question: Was there something illegitimate economically about hoarding and then dumping physical crude inventories? According to the various press accounts, I have not seen any allegations of actual fraud on the part of the traders. For example, they didn’t buy the oil, blow up one of their warehouses, and then falsely tell the police, “We lost all of our oil in the blaze.”

No, it appears (on the basis of the press accounts) that they simply purchased large holdings of physical crude, and others in the market assumed that the oil was being used for refining or other purposes. It was thus a surprise when the oil was dumped back into the market at the end of January, a few weeks later.

To repeat, to the extent that this “trick” really worked, it didn’t change the long-term price of oil (or gasoline). The $50 million profit reaped by these traders would have come largely at the expense of other oil traders (not average consumers) who were caught with their pants down both on the way up and on the way down in the futures market.

Going forward, savvy competitors presumably would have tried to avoid such a trick in the future. If they saw an apparent tightness in the Cushing physical market, they would think twice before pushing up the futures price, since it might come crashing down a few weeks later. People can’t simply make $50 million automatically, month after month, in the commodities and futures markets, the way the critics seem to think. Other speculators would adapt and quickly stamp out such opportunities.

The problem with giving government regulators the task of stamping out such “anti- social” trading is that they will mute the ability of the market to respond to genuine threats of crude shortages. Because of the lawsuits, oil traders will be less willing to acquire physical inventories even if they believe the fundamentals justify a rising price over time. Such traders would be afraid that the government would accuse them of causing the movement in prices, even if they were genuinely just trying to anticipate it.

Conclusion

So long as they don’t use violence or fraud, people in a market economy generally make profits by serving others. This is easy to see in the cases of successful entrepreneurs like Bill Gates or Oprah Winfrey. It’s not as easy to understand when it comes to successful traders in the futures market, but the presumption is still present. Whether or not the defendants in the recent CFTC case actually broke the law, the charges against them will weaken the market’s ability to adapt to future supply and demand conditions in the oil industry. Finally, people should always keep in mind that speculators drive prices down in response to good news. When President George W. Bush announced the end of the Executive Branch moratorium on offshore drilling, oil futures prices fell $9 during the speech.

Written Testimony of

Robert P. Murphy, Institute for Energy Research

Before the Subcommittee on Regulatory Affairs, Stimulus Oversight, and Government Spending

On the Matter of

“How Federal Reserve Policies Add to Hard Times at the Pump”

May 25, 2011

1. About IER

The Institute for Energy Research (IER) is a not-for-profit organization that conducts intensive research and analysis on the functions, operations, and government regulation of global energy markets.  IER maintains that freely-functioning energy markets provide the most efficient and effective solutions to today’s energy and environmental challenges and, as such, are critical to the well-being of individuals and society.

Founded in 1989 from a predecessor nonprofit organization, IER is a public foundation under Section 501(c)(3) of the Internal Revenue Code and is funded entirely by contributions from individuals, foundations and corporations.  Headquartered in Washington, D.C., IER supports public policies that simultaneously promote the welfare of energy consumers, energy entrepreneurs, and taxpayers.

2. Robert P. Murphy Resumé

Robert Murphy earned his Ph.D. in economics from New York University in 2003.  From 2003 – 2006 he taught economics at Hillsdale College.  After three years teaching, Murphy left academia for the private sector, taking a job with Laffer Investments, headed by Arthur Laffer of “Laffer Curve” fame.  In this capacity, Murphy maintained and improved stock selection models, and also helped write research papers for clients.  One of the Dr. Laffer’s main interests in this period was oil prices.

In the summer of 2007 Murphy joined IER as an economist.  His academic research has focused on climate change economics, specifically the proper discount rate to use when evaluating mitigation policies.  He has also given several public presentations on the oil industry, dealing with such issues as record oil prices, windfall profits taxes, and offshore drilling.  In addition, Murphy has prepared studies for IER dealing with oil and food prices, the effects of ethanol on gasoline prices, and the role of institutional speculation in oil prices. Murphy previously testified (having been invited by Dr. Ron Paul [R-TX]) on the connection between the weakening dollar and oil prices on July 24, 2008.

3. The Causes of High Gasoline Prices

Although gasoline prices are still below the record levels (not adjusting for price inflation) set in the summer of 2008, they have been higher in the early months of 2011 than ever before:

Gasoline prices are driven by a few major factors, as the following chart from the Energy Information Administration (EIA) illustrates:

If policymakers want to reduce prices at the pump, the two most relevant components of gasoline prices are federal and state taxes, as well as the price of crude oil. Federal policymakers clearly have the ability to lower the federal tax of 18.4 cents per gallon, while state officials could lower the respective fuel taxes in their jurisdictions. This would provide immediate relief at the pump, though depending on (what economists call) the relative elasticities of supply and demand, not all of the tax reductions would be passed along to motorists. For a purely illustrative example, even if the 18.4 cents per gallon federal tax were completely eliminated, the price at the pump might only fall by (say) 10 cents per gallon, meaning that retailers would earn an extra 8.4 cents per gallon themselves.

Moving on to the price of crude oil, at first it might seem as if federal policymakers have little influence on a commodity traded in the world markets. However, by expediting the development of offshore and other mineral resources on federal lands, policymakers could signal an increased future output of crude oil which would actually reduce prices even in the present. For example, when President George W. Bush announced in the summer of 2008 that he was ending the executive branch’s moratorium on offshore drilling, the price of oil dropped $9 during the speech itself.[1]

In addition—and of more relevance to this hearing—the Federal Reserve has a tremendous influence on the value of the dollar and the financial markets, and as such may have played a significant role in the sharp run-up in crude oil prices over the last few years.

4. The Federal Reserve’s Role in Rising Crude Oil Prices

After hitting record highs in the summer of 2008, the price of crude oil crashed amidst the financial crisis and slowdown in world economic growth. After hitting a low of $33.87 per barrel on December 19, 2008, the benchmark price of a Cushing oil futures contract had risen to $96.91 by May 17, 2011.[2] The following chart illustrates the wild swings in the oil market:

There are two main routes through which Fed policy could have influenced oil prices (quoted in dollars). First, the Fed could have caused the dollar to depreciate against other currencies. Second, the Fed could have raised the price of oil relative to most other goods and services. In the remainder of this written testimony, I will first lay out the extraordinary interventions of the Federal Reserve in the wake of the financial crisis, and then turn to each of the two possible connections to oil prices.

a) The Extraordinary Interventions of the Federal Reserve

The Federal Reserve has engaged in several extraordinary measures since 2007 to deal with the developing financial crisis. The Federal Reserve Bank of New York has compiled a timeline of these specific interventions.[3] In addition to cutting the federal funds target interest rate to virtually zero, the Fed has expanded its balance sheet by purchasing mortgage-related derivatives and Treasury debt. The following chart of the “monetary base” (a measure of physical currency in circulation plus banks’ electronic deposits with the Fed) indicates the scope of the purchases:

As the above chart indicates, from the creation of the Fed in late 1913 up until September 2008, the monetary base grew by a little more than $932 billion. From September 2008 until the present, the monetary base has grown by an additional $1,595 billion.[4] The Federal Reserve has clearly embarked on unprecedented injections of liquidity into the financial system during the last few years.

b) Dollar Depreciation and Oil Prices (Quoted in USD)

The U.S. dollar’s fortunes have varied during the financial crisis and its aftermath. In the midst of the global panic in the fall of 2008, the dollar strengthened sharply against other currencies, presumably because investors around the world began moving their wealth out of riskier assets and into conservative Treasury debt issued by the U.S. government. (If a foreign investor wants to sell assets denominated in other currencies and buy dollar-denominated assets such as U.S. Treasuries, this will require the other currencies to be sold in order to buy dollars, which in turn will tend to cause the price of a dollar to rise in the other currencies.)

However, as the global financial panic subsided and (presumably) in light of the Fed’s large injections of new dollars into the banking system, the dollar sank back to its pre-crisis levels. The following chart shows a (trade-weighted) index of dollar strength against other major currencies for the last ten years:

Crude oil is traded on a world market. If the dollar falls against another currency, such as the euro, then either the euro-price of oil has to fall, or the dollar-price of oil has to rise, to eliminate arbitrage profits. From its peak in March 2009, the dollar has fallen 17 percent against other major currencies.[5] Therefore, holding everything else constant, the dollar deprecation alone from early 2009 can explain a 20.5 percent increase in oil prices (quoted in dollars).[6] Put differently, the oil price quoted in (say) Japanese yen has not risen as much since early 2009 as it has in U.S. dollars.

It is on the basis of such calculations that a recent Joint Economic Committee report estimated that Federal Reserve policies have added almost 57 cents to the price of a gallon of gasoline for American motorists.[7] However, this calculation assumes that the entire drop in the value of the dollar (relative to other currencies) since the announcement of the first round of “quantitative easing” (in late 2008) has been due to investor concern over U.S. inflation. One could plausibly argue that the retreat from the panic of that period has also led investors to shift some of their wealth away from U.S. Treasury debt and into riskier assets, thus reversing the sharp increase in the exchange value of the dollar that began earlier in September of 2008.

In a sense, both perspectives attribute the fall in the value of the dollar to the actions of the Federal Reserve, but the latter interpretation (that the Fed averted a financial meltdown) is of course less critical than the former (that the Fed debased the dollar). In either case, the JEC estimate of the Fed’s impact on gasoline prices only looks at the direct mechanism of monetary policy’s influence on the exchange value of the dollar relative to other currencies. The JEC analysis does not consider the possible role the Fed has played in pushing up oil and other commodity prices, regardless of the currency in which they are quoted.

c) Commodity Price Surge as Inflation Hedge

In addition to causing oil prices (quoted in dollars) to rise because of a weakening dollar, Federal Reserve policy may also affect oil prices more directly to the extent that it has caused investors to shift some of their wealth into commodities as an “inflation hedge.” For example, since September of 2008, gold and silver prices have increased some 80 percent and 210 percent, respectively.[8] A certain segment of investors and the general public are very concerned about the future purchasing power of the dollar, and have invested in the precious metals to protect themselves from potentially large future price inflation.

More generally, some investors may be turning to other commodities (including oil) thinking that they will provide a relatively safe store of value, in the event that the dollar and other paper currencies weaken in the future. However, although this theory has a surface plausibility, in practice it is difficult to distinguish it from an explanation that oil’s price rise is due to “the fundamentals,” i.e. a genuine growth in end-user demand for oil relative to the increase in output.

If investors in the financial markets were in fact partially responsible for increasing the world price of oil (due to their efforts to protect themselves against currency depreciation), economists would expect to see a “speculative signature” in the form of inventory accumulation. The following diagram illustrates the logic:

As the above diagram indicates, if the actual spot market price were being held above the “fundamental” price, then producers ought to be increasing output while end users (such as oil refiners) would cut back on their purchases. The excess output over current consumption would then go into inventory accumulation.

Through mid-July 2009, there was evidence of a large-scale inventory buildup in crude oil. On July 8, 2009, Paul Krugman wrote that although he thought the run-up in oil in the summer of 2008 had been due to fundamentals, the price rise in the first half of 2009 was associated with bulging inventories in both tankers and conventional storage, suggesting that investor behavior in the futures markets could be partially responsible this time around.[9] However, the trend reversed in the second half of 2009. Looking at the entire period, official U.S. inventories of crude oil and petroleum products as tracked by the EIA as of February 2011 were 36.7 million barrels higher than in December 2008, an increase of a little more than 2 percent.[10] Thus inventories in the United States have grown, but the growth alone is hardly enough to explain the huge increase in the price of oil over the period in question.

Although there is no “smoking gun” in U.S. data, it is important to note that worldwide oil inventories are much harder to estimate. Only the OECD countries provide regular reporting on inventories to energy agencies. A potentially large source of error is China, which has been aggressively building strategic petroleum storage capacity while not being transparent as to exactly how much of its “oil demand” is actually being diverted into stockpiles, rather than being consumed.[11]

Besides storing oil above ground, another mechanism through which the actual market price could be held above the “fundamental” price would be a cutback in production. In effect, the owners of oil fields would be stockpiling inventory out of regular output underground.

The possibility of constrained output leading to the run-up in world price is consistent with the behavior of OPEC nations, as they have kept their official production quotas at the curtailed levels implemented after the global economic slowdown in late 2008, even as the world price recovered from its brief collapse. However, even though OPEC nations have constrained their production, output from other sources has more than compensated for the gap. Overall, estimated total world output of oil in the first quarter of 2011 was the highest ever.[12]

5. Conclusions

The Federal Reserve has engaged in unprecedented interventions in the financial system in the wake of the 2008 financial crisis. To the extent that the Fed’s actions have caused the U.S. dollar to fall against other currencies and led some investors to seek commodities as a hedge against price inflation, the U.S. central bank is partially responsible for the large run-up in oil prices since early 2009.

However, it is very difficult to isolate just how much of the price hike can be explained by Fed policy, versus “fundamental” factors such as the fall in Libyan production and the increasing oil demand from emerging markets. Absent very reliable worldwide data on inventory accumulation, the relative influence of monetary policy versus “real” factors specific to the oil market cannot be precisely quantified.

If policymakers want to lower the price of gasoline for American consumers, they have several options. Most obvious, they could reduce federal and state gasoline taxes. They could also expedite the regulatory and permitting process for the development of offshore and other domestic oil resources. Finally, with respect to the Federal Reserve, to the extent that a tighter monetary policy would strengthen the dollar and reduce investor concern about future price inflation, we would see lower crude oil prices and hence lower gasoline prices. It is notoriously difficult though to estimate the quantitative impacts of these policies, because market prices are influenced by so many different factors.

You can download a PDF of this testimony by clicking here.

Even among free market economists, the issue of tax deductions and credits is controversial, because it mixes the twin goals of tax simplification and tax reduction. However, what is crystal clear is that the popular arguments used to support the change in tax law don’t stand up to scrutiny. By effectively hiking taxes on oil producers, the government will not reduce oil prices—if anything it will raise them. Furthermore, the facts show that “Big Oil” is already “paying its fair share” in taxes. The sudden debate over tax policy seems more about a cash-strapped government going after deep pockets than about equity in the tax code.

Oil Profits and Oil Prices: Reversing Cause and Effect

Whenever discussing an effective tax hike on oil companies, President Obama and other leading Democrats constantly remind the public that these companies are earning very large profits while the average motorist groans because of the price at the pump. The implication is that the oil companies’ profits are the cause of high oil prices.

For example, in conjunction with introducing a windfall profits tax, Dennis Kucinich (D-OH) declared, “Consumers are being gouged at the gas pump,” and went on to say, “The only thing rising faster than the price of gasoline right now is the skyrocketing profits of the oil companies.”

Kucinich and others have things backward. High oil profits don’t cause high oil prices. On the contrary, high oil prices lead to high profits. Slapping a higher tax liability on major oil producers would certainly reduce their after-tax profits, but it wouldn’t reduce oil prices or what motorists pay at the pump. If anything, squeezing more tax revenue out of major oil companies would increase world oil prices, by reducing supply.

This principle shouldn’t be too hard for environmentalist opponents of oil companies to understand. Whcaat is their suggested tool to get companies to restrict the output of carbon-based energy? Why, to levy a tax on such operations.

President Obama and others who have supported the principle of a carbon tax (or cap-and-trade) can’t have it both ways: If they believe a tax on carbon will cause companies to shift out of carbon-intensive activities, then they should openly admit that hiking taxes directly on oil producers will, if anything, reduce the supply of oil and hence increase energy prices.

Equality Before the Law

Regardless of the other considerations, there is something unseemly when the government edits tax rules to raise $20 billion from five companies. For an analogy, if a local government said, “Motorists can turn right on red, unless their first name is Mortimer,” then this would be a travesty of the rule of law.

The situation is not far different when it comes to the proposed change in the tax code. Part of the changes would deny the (Section 199) Domestic Manufacturing Deduction that was originally put in place in 2004 to encourage American manufacturers to keep jobs in the United States, rather than outsourcing them. If policymakers think that the high deficit trumps these considerations, then by consistency they should eliminate the tax deduction altogether. It only further complicates the tax code by denying that particular tax deduction to five particular companies who had previously been qualified as manufacturers (because they produce oil and natural gas domestically).

In commenting on this episode, Freeman editor Sheldon Richman—hardly a friend of Big Business—wrote:

Discretion is dangerous. Politicians don’t need the traditional power of a central planner to impose economic schemes. All they need is the power to write differential tax policy. Virtually anything that can be done by regulatory decree can be also done by selective tax preferences….When government can shape economic behavior through the tax code, there surely is no free market. Tax neutrality is a chimera, but we should still object whenever the tax writers try to manipulate the economic process.

Putting Things in Perspective

In light of the bombastic rhetoric surrounding this issue, the average American probably believes that (a) the oil industry earns a much higher profit than other industries and (b) oil companies don’t pay much in taxes. Yet it turns out both claims are myths. The following charts are from the American Petroleum Institute (API), an industry trade group. They set the record straight and put things in perspective.

The first chart shows that oil and natural gas companies do not earn an unusually large amount per dollar of sales. In other words, their “markup” is actually much lower than that in many other industries:

The reason large oil companies can have such enormous total profits is that they have enormous revenues: Simply put, the majors such as Exxon and others sell a lot of product to consumers, and so their relatively tame profit-per-dollar adds up to a large total profit. Yet high profits aren’t a sign of bilking the public; on the contrary they are a sign that the company is serving its customers while keeping costs down.

The next chart shows that the major oil and natural gas companies had effective income tax rates in 2010 far higher than the average of the other members of the S&P 500:

The reader should interpret the above chart with care; the income taxes do not all necessarily go to the U.S. Treasury, because multinational corporations have worldwide operations and try to structure them to minimize their tax bite. Even so, the fact remains that oil and natural gas companies in 2010 owed 41.1 percent of their pre-tax income as tax to various governments. (As this Forbes article explains, oil and gas companies are actually at a disadvantage in this respect compared to most other multinationals, because other governments charge relatively high amounts on their activities.)

In any event, the U.S. federal government extracts billions from the major oil companies every year in taxes and other fees. They are huge, profitable companies that generally suffer from a poor reputation among the public. Of course the government has been exacting tribute from them, all along.

Conclusion

In terms of promoting economic growth, to design an efficient tax code from scratch would have low, flat rates and a very wide tax base (meaning few or no deductions or credits). The goal would be to raise the desired amount of revenue with as little distortion as possible to the allocation of resources across different sectors. The government shouldn’t use the tax code to pick winners and losers.

In the present context, policymakers are not starting from scratch, but are working with the tax code as it currently exists. The proposal to deny certain provisions of the tax code to a handful of rich companies is hardly an effort in tax simplification. Moreover, much of the rhetoric behind the proposal is based on myths. Hiking taxes on oil companies won’t reduce oil prices, and these companies already pay large amounts to the U.S. and other governments.

A recent headline on the opinion page of the New York Times proclaimed: “Pain at the Pump? We Need More.” Authors Daniel Esty and Michael Porter recommend new gasoline levies as an elixir to our budget deficit and to rectify our energy sins. Their tax would start small “[to] make the short-term burden … almost negligible” but increase twenty-fold by year twenty.

As bad as the above mindset is for consumers and the economy, the candor is commendable. President Obama will not dare say the same, although his energy/environmental advisors such as John Holdren are comrades-in-arms with Caperton, Esty, and Porter. Instead, Obama is fingering scapegoats (the oil companies, speculators)—as if the bad guys and gals had suddenly decided to get greedy and world supply/demand conditions were tangential.

Remembering Al Gore

Obama’s misdirection and hypocrisy bring to mind presidential candidate Al Gore on the campaign trail back in mid-2000 when high gasoline prices were an issue. Did the numero uno climate alarmist praise the price trend as a step toward saving a “dysfunctional” society?[1] After all, this is the man who wrote: “We now know that [the automobile’s] cumulative impact on the global environment is posing a mortal threat to the security of every nation that is more deadly than that of any military enemy we are ever again likely to confront.”[2]

And did Gore seize the moment to advocate a big tax increase given what he also penned:

Minor shifts in policy, marginal adjustments in ongoing programs, moderate improvements in laws and regulations, rhetoric offered in lieu of genuine change—these are all forms of appeasement, designed to satisfy the public’s desire to believe that sacrifice, struggle, and a wrenching transformation of society will not be necessary.[3]

Well, none of the above came to pass with Gore on the campaign trail; quite the opposite.  “I think we need to bring gasoline prices down,” he intoned.

I have made it clear in this campaign that I am not calling for any tax increase on gasoline, on oil, on natural gas, or anything else. I am calling for tax cuts to stimulate the production of new sources of domestic energy and new technologies to improve efficiency.[4]

To which his erstwhile climate ally Bill McKibben complained:

No American politician can bear to do anything to restrict our piggish use of coal and gas and oil–not to raise energy prices or legislate against the plague of gas-guzzling SUV’s. During the campaign, Mr. Gore even demanded that the Strategic Petroleum Reserve be opened to keep fuel prices down.[5]

Post-election, of course, Al Gore reverted back to his old ways. “The leading experts predict that we have less than 10 years to make dramatic changes in our global warming pollution lest we lose our ability to ever recover from this environmental crisis,” he stated eight years after his narrowly failed presidential run. Little doubt Gore would endorse a new gasoline tax à la Esty and Porter, and higher electricity prices as well.

Conclusion

Politicians do not dare repeat the performance of April 18, 1977, where Jimmy Carter interrupted the television shows to give what became known as the “malaise speech”.

“To some degree, the sacrifices will be painful—but so is any meaningful sacrifice,” the president solemnly said that evening. “It will lead to some higher costs and to some greater inconvenience for everyone.”

Sacrifice for the common good is a very bad sell to Americans—as it should be. Andrew Revkin recently blogged about how “the environmental movement … confronts a century in which mainstay messages such as ‘woe is me’ and ‘shame on you’ will have ever less relevance.” After all, as Daniel Yergin wrote 20 years ago in The Prize:

Hydrocarbon Man shows little inclination to give up his cars, his suburban home, and what he takes to be not only the conveniences but the essentials of his way of life.  The peoples of the developing world give no indication that they want to deny themselves the benefits of an oil-powered economy, whatever the environmental questions. Any notion of scaling back the world’s consumption of oil will be influenced by the extraordinary population growth ahead.[6]

Government intervention at home and abroad has made electricity and gasoline artificially scarce. An energy intelligentsia telling Americans to both double-down on government and increase their pain is a loser in every which way. A new mentality is needed that favors consumers, producers, and the general economy. That means an expansion of private property rights and free markets for energy at home and abroad, not the opposite.

Although it might provide emotional relief, punishing speculators is a classic case of shooting the messenger. And whatever the merits of restructuring the tax code, surely raising liabilities for oil producers won’t make them increase activity.

If President Obama really wants to get to the heart of rising oil (and food) prices, he should have a long talk with Ben Bernanke, whom he reappointed as Chairman of the Federal Reserve. By flooding the world with dollars, Bernanke has driven up commodity prices across the board as the dollar depreciates.

Speculators Are Doing Their Job

As I explained in a previous post, speculators in the commodities markets are doing exactly what we want them to do, in light of the events in the Middle East. To understand (partly) why oil has risen so much in recent months, I can quote from Obama himself:

The problem is … speculators and people make various bets, and they say, you know what, we think that maybe there’s a 20 percent chance that something might happen in the Middle East that might disrupt oil supply, so we’re going to bet that oil is going to go up real high. And that spikes up prices significantly.

To reiterate, this is the textbook function of socially beneficial speculation. If there is a possibility that prices will rise sharply in the near future, then current prices should rise to reflect that reality. The higher price leads to more careful usage of the resource, while it simultaneously prods other producers to ramp up their output.

The current configuration of oil prices—both in terms of the spot market and the “futures” prices at various dates—give the incentive to pump oil as fast as possible[1] (to earn the high prices while they last) and to stockpile the excess production. In the event that extraction capacity is impaired because of the Libyan war or some other political event, we will be glad to have extra inventories.

It’s true that sometimes speculation can get caught in a self-fulfilling prophecy, and push an asset up into an unsustainable bubble. (This is what happened with real estate prices in a few years ago.) Nobody is claiming that people in the financial sector are infallible. The point, however, is that speculators are only bidding up the price of oil today, because they anticipate—and with good reason—that it will be higher in the near future. To blame high oil prices on speculators is akin to blaming winter on thermometers.

If President Obama wants to harness the forces of financial speculation the other way, all he needs to do is announce policies that favor increased domestic production of oil. When President Bush ended the executive moratorium on offshore drilling in 2008, the financial markets pushed down the price of crude oil by $9 per barrel during the speech.

Since When Do Tax Hikes Lead to Lower Prices?

The issue of simplifying the tax code is full of nuances. For those who favor a free market, where the government doesn’t pick winners or losers, the best tax code (if we must have a tax code at all) is one that has low marginal rates and a wide base. The objective is to raise the desired amount of revenue with as little distortion to what the market would have done in the absence of such taxation.

Unfortunately, we are not designing a tax code from scratch, but are taking the current, convoluted creature as the starting point. In this context, the twin goals of “eliminating tax loopholes” and “reducing the burden on the private sector” conflict with each other. Economists and other policy wonks can have honest disagreements about the desirability of removing this or that “tax subsidy” to energy companies or any other group.

However, what should not be in doubt is that raising taxes on a particular industry will decrease output and raise prices for consumers. It is therefore nonsensical when President Obama, Dennis Kucinich and others suggest that a proper remedy for high gas prices is to saddle Exxon and others with higher tax bills. Yes, the high price of oil has a lot to do with the high profits of oil companies, but it doesn’t follow that taxing away more of the oil companies’ profits will therefore reduce oil prices.

Ironically, the environmentalist left should understand this principle quite well. What do they recommend to get people to use less carbon-intensive goods? Why, they recommend imposing a tax on such activities. In the context of a carbon tax, the left understands basic economics: If you want to discourage people from doing something, you impose a tax on it.

Turn back to oil prices. If the government wanted to reduce oil production and thereby increase oil prices, it should impose higher taxes on oil producers. If the goal instead (as Obama and Kucinich claim) is to lower oil and gas prices, then they should be calling for tax breaks for those companies in the business of producing and refining oil.

In another ironic twist, it turns out that historically, high oil prices go hand-in-hand with higher effective tax rates on oil companies. In other words, given the complexities of the current tax code, the actual percentage of the oil majors’ income going to Uncle Sam is higher, when the price of oil is high. For example, in 2008 the effective rate was 42.3 percent, but in 2009 (when the average price of oil was far lower) the effective tax rate had plummeted to 26.3 percent. In this respect, people who want the oil majors to “pay their fair share” should actually be rooting for high oil prices.

The Role of the Federal Reserve

Beyond the short-term price hikes due to the political situation in the Middle East, the price of oil has risen along with other commodities because of Ben Bernanke’s monetary policies. The graph below shows the changing fortunes of the US dollar and crude oil prices, quoted in dollars:

As the financial crisis set in during the fall of 2008, the price of oil (red line, right axis) collapsed from its all-time highs. At the same time, the dollar (blue line, left axis) appreciated strongly against other currencies, as investors sought a safe haven in U.S. Treasury securities. (When foreign investors want to buy American assets, they have to sell their own currencies to buy dollars.)

But these trends reversed in early 2009, when Ben Bernanke announced the first major round of “quantitative easing.” Since its 2009 peak, the dollar index has fallen about 15 percent against other currencies, while the price of crude oil has more than tripled. So some of the price rise in oil (quoted in dollars) is directly due to the falling dollar itself, as oil is traded on world markets and must be the same price to all buyers (quoted in their own currencies).

However, it would be wrong to conclude that most of the rise in oil is due to the its “fundamentals.” Investors around their world are rushing into commodities (in part) to hedge themselves against the possibility of significant future price inflation. The Fed and other major central banks have been creating money at full tilt since mid-2008, and many investors want to avoid getting wiped out by a possible flood of price rises. Because the economy is so awful, many investors are heading into things that will always be useful, namely commodities.

To underscore that this isn’t merely an issue of the “fundamentals” of crude oil, note that gold is hitting all-time highs while silver has more than doubled in the last 12 months alone. Yes, in one sense all of these moves are caused by “speculators,” but they are speculating with good reason: Bernanke and other central bankers are injecting more liquidity into the financial sector than has ever been done in world history.

Conclusion

Markets are complex and there are many reasons for particular price movements. However, when it comes to high oil prices, we can be fairly confident in saying that new tax hikes will not fix the problem, while tighter Fed policy would.

We have already discussed President Obama’s support for Brazilian offshore drilling, even while his Interior Secretary continues to drag his feet on granting permits for domestic development off American shores.

Source: U.S. Dept. of Energy

Other examples of this split-personality syndrome are those calling to draw down the Strategic Petroleum Reserve (SPR). Proponents of this plan argue that the increased availability of oil would lower gasoline prices and help beleaguered Americans. Yet many of these same people do not support drawing down the petroleum “reserves” sitting in the ground in ANWR or on the Outer Continental Shelf.

This strategy baffles us, because the SPR is a smaller stockpile than the other deposits that are currently off-limits to development. Furthermore, economic theory suggests that ending the permitorium might reduce oil prices right now even more than drawing down the SPR.

Senator Jay Rockefeller: More Oil Helps Americans

In a recent USA Today op ed, Senator Jay Rockefeller gave a standard case for tapping into the SPR. Here are some excerpts in which Rockefeller makes the obvious connection between abundant energy and a healthy economy:

Gas prices are not just a short-term inconvenience — they are an unsustainable burden on our economy and a challenge to our efforts to bring this country out of the greatest economic recession since the Great Depression. Rapidly rising gas prices caused by threats to the global oil supply hurt business and industry.

To reduce the very real burden on Americans and address any further oil supply disruptions, I have asked President Obama to consider releasing oil from the Strategic Petroleum Reserve.

We sympathize with Rockefeller’s explanation. High gasoline (and other energy) prices are a burden on Americans, and pose a drag on the economy which is already struggling. We simply point out that Rockefeller is unwittingly making a stronger argument for removing the federal impediments to the development of America’s oil reserves.

Comparing the SPR with Other “Reserves”

According to the official website, the Strategic Petroleum Reserve (as of late November) had a total of 726.5 million barrels of oil stockpiled for an emergency, with 434 million barrels of sour crude and the balance consisting of sweet crude. Although an impressive figure, the number pales in comparison to the estimated crude domestically available in areas currently off-limits to development.

For example, the “1002 Area” of the Arctic National Wildlife Refuge (ANWR) has a mean expected 10.4 billion barrels of technically recoverable oil, according to the government’s own survey. Once up and running, ANWR alone could yield one million barrels of oil per day in production, which would make it the single-largest producing field in North America.

If we turn our attention to the Outer Continental Shelf—of which 97 percent does not have leases for development—again the government’s own estimates claim there are 86 billion barrels of oil.

If policymakers think it makes sense to tap into the SPR, with its relatively tiny 726.5 million barrel stockpile, why not allow American companies tap into the other reserves under their jurisdiction? ANWR and the OCS combined have more than one hundred times the amount of oil stored in the SPR.

Lowering Prices Now or in the Future?

Back in 2008, I testified to Congress on the matter of rising oil prices (see part 1 and part 2). Naturally I made the case that if the government wanted to lower gasoline prices, it should eliminate its (then still official) moratorium on offshore drilling and other impediments to oil exploration on federal lands.

The main objection I received was that even if full approval were granted immediately, it might take years for new fields to reach maximum production levels. This supposedly meant that removing the official moratorium would do nothing to bring immediate price relief to motorists.

First, it’s important to point out that had my analysis been heeded back in July 2008, we would have had three years of progress under our belts before this summer’s potentially record gas prices hit. It’s not as if the American economy’s need for energy is a fleeting goal. If bringing extra oil deposits into development would help in a few years, then it makes sense to get the wheels in motion now. Nobody says that it’s pointless to send your kid to school, since the payoff is years in the future.

However, that’s not the end of the story. When then-President George W. Bush removed the executive moratorium—even though the Congressional version was still in effect—oil prices dropped more than $9 during his announcement.

This wasn’t magic; other analysts and I had been predicting that it would happen, if the federal government were to loosen its choke-hold on domestic development. A little economics will explain what happened:

The owner of a given oil field has an exhaustible resource at his disposal. He has to decide whether to extract more barrels for sale in the present, or if he should slow his production and leave more barrels in the ground for sale in the future. One of the primary influences in this calculation is the owner’s guess as to whether oil prices will be higher in the future, compared to the present. (I spell out the argument more fully here.)

Now suppose the owner learns some new information, telling him that there will be more oil production occurring in a few years. (For example, the president of the United States lifts the executive moratorium on offshore drilling, making it more likely that Congress will follow suit and that drilling will actually occur.) That means his previous estimate of the future price of oil was too high; oil in fact will be cheaper down the road, because of the new oil production.

Whatever his previous decision on how many barrels to produce this year, the new information will give the owner an incentive to bump up the number, because now the current spot price of oil is more attractive compared to his new (and lower) estimate of the future price of oil.

So we see that there’s no magic involved, no time machines bringing future oil into the present. Current oil producers with excess capacity—such as Saudi Arabia—can increase output immediately, and bring immediate price relief, if the U.S. government takes steps that will yield higher global oil output down the road. To repeat, this isn’t just theory; oil prices really did drop significantly in response to the lifting of both the executive and congressional moratoria in 2008.

Selling From the SPR Could Backfire

Ironically, the same logic shows that selling oil from the SPR might have much less impact than we might otherwise expect. As University of Rochester economist Steve Landsburg pointed out in his critique of Senator Rockefeller, we can’t look at U.S. policy in a vacuum.

If the government begins releasing oil from the SPR, it’s true that the extra barrels on the market would tend to push down the current price of oil. But that means other oil producers would now have an incentive to slow their current production, to hold more of their barrels off the market until the future, when prices will be relatively higher.

To be sure, selling oil from the SPR wouldn’t make oil prices go up, but Landsburg’s point is that they might not drop very much, because other producers could offset much of the impact.

Conclusion

If policymakers such as Senator Rockefeller want to bring relief to Americans through lower gasoline prices, we agree that increased oil supplies on the market are an obvious solution. However, compared to drawing down the SPR, there is a much more compelling case for allowing the development of domestic oil resources.

Thomas Malthus

growth was exponential (2-4-16) while the food supply only grew arithmetically (2-3-4).  Malthus argued that this relationship between population and food supply was a recipe for social catastrophe.

History has shown time and time again that Malthus was wrong. The population growth has not outstripped the food supply.  Malthus’ predicted social catastrophe never happened because necessity is the mother of all inventions — when more food was needed to feed a growing population, there were innovations or alternatives discovered.

When it comes to energy, Malthus lives on with those who believe in peak oil.  Peak oil is the idea that humans have reached the point of maximum oil production, and that proven reserves will be depleted. Despite these claims by peak oil alarmists, world proven reserves have doubled since 1980.

Some peak oilers point to the U.S. and note that U.S. proved oil reserves are down slightly from their 1980 levels. This is true. It’s also true that in 1980 the U.S. had oil reserves of 29.81 billion barrels. From 1980 through 2009, we produced 75.36 billion barrels of oil. In other words, we produced 250% of our proved reserves over the last 30 years.

In light of the conflicts in the Middle East, I am sure we will see the resurgence of peak oil claims that are artfully designed to encourage the taxpayer into thinking we need to further subsidize renewable energy. In order to combat the emotional pleas of Malthusians, here are a few fun facts from Reason and a great video from Learn Liberty that explains how resources are conserved and preserved:

• In 1855 there was an advertisement for Kier’s Rock Oil, a patent medicine whose key ingredient was petroleum bubbling up from salt wells near Pittsburgh, urged customers to buy soon before “this wonderful product is depleted from Nature’s laboratory.”
• In 1943 the Standard Oil geologist Wallace Pratt calculated that the world would ultimately produce 600 billion barrels of oil. In fact, more than 1 trillion barrels of oil had been pumped by 2006.

Any guesses on how much oil we will have in 20 years? I’m guessing 2 trillion barrels.

However, the market economy already has mechanisms, such as futures markets, to handle volatility in commodities such as oil. Private-sector analysts are aware of the geopolitical situation and have been acting accordingly. If future disruptions in oil output were truly so serious as to make it uneconomical as a major energy source—all things considered—then the market would naturally move away from oil.

The government doesn’t need to pick winners and losers in the energy markets. If officials want to “do something,” they should free up domestic production of energy and stop the regulatory crackdown on speculation in the financial markets.

The Price of Oil Already Reflects the Risks of Future Crises

Even though they are almost universally reviled, speculators perform a vital function in the market economy. Speculators anticipate future conditions and then (unwittingly) adjust current market prices to reflect these possible scenarios.

For example, as the situation in various oil-exporting nations began deteriorating, speculators realized that there was a serious possibility of a major disruption in crude oil reaching the international market. If supply were interrupted, the price of a barrel would need to rise, to ration the remaining barrels among the competing buyers.

This is why the price of oil began to rise even before the physical disruptions. The old, everyday price of oil was too low, in light of the new political events. Seeing a price (say) of $90 per barrel, and knowing that there was a good chance oil might break $100 the following week, speculators had an incentive to start stockpiling oil and thereby push up its price right away. (In modern financial markets, futures contracts make this process smoother, as I explain here.)

Some cynics object to the “profiteering” of speculators (and “Big Oil”) when a political situation apparently gives them an excuse to raise prices, but in fact this is precisely what consumers want to happen. Speculators actually reduce price volatility over the long term, because speculators—by “buying low and selling high”—push up prices that are too low (in relation to their future level), and they reduce prices that are too high.

To repeat, this is exactly what we want speculators to do; they are providing a service to us all, as long as they correct anticipate price swings and act profitably. For example, if the speculator buys low and sells high, then he effectively moves oil from a time of relative abundance (when the price was low) to a time of relative scarcity (when the price was higher).

The current surge in oil prices not only reflects the actual state of world oil production and consumption, but also reflects the possibility that more serious disruptions could occur down the road. The government doesn’t need to stack the deck against oil; people in the private sector are already aware of these issues.

Oil Still an Efficient Energy Source

Despite the periodic reduction in supplies from unstable regions, all things considered oil remains an efficient source of energy for the United States over the foreseeable future.

For one thing, regardless of which political faction takes power (in Libya, Saudi Arabia, Iran, etc.), the group can only benefit financially if they sell their oil to the world. To win a revolution in Libya, only to renounce oil exports, would be akin to robbing a bank and then dumping the cash out the window of the getaway car. We should also remember that oil is a very fungible commodity; even if a particular regime refuses to export to the United States, other countries would simply rearrange their crude flows to offset the change.

We can certainly dream up scenarios where it really would make economic sense to switch away from oil into other energy sources, very quickly. For example, if oppressive rulers in the Middle East managed to destroy large amounts of their country’s resources, so that the price of crude spiked to (say) $400 per barrel and would remain there for years, then many Americans would rationally start abandon their SUVs (especially the older models) and switch to hybrids, electric cars, mass transit, and bicycles.

Yet notice that even in this contrived example, the government wouldn’t need to steer people into making the right choice. That’s the whole point of a market economy with its price signals. Each household would need to look at the outrageous price of gasoline (if crude really jumped to $400 per barrel), and make hard choices about how to get around town. The government wouldn’t add anything constructive by slapping an extra tax on oil, or subsidizing mass transit. All that would do is distort the true choice facing consumers.

Conclusion

The government doesn’t need to stack the deck for or against oil. Yes, there are occasional disruptions in the supply to world markets from certain regions. But the market already has mechanisms (such as the futures market) where speculators can profit in direct proportion to how well they give early warning of such disruptions. The system isn’t perfect, but government employees don’t have crystal balls either. (They certainly didn’t see Mubarak’s regime tumbling.)

All things considered, oil still remains a vital and efficient energy source in the American economy. To renounce it because of the situation in the Middle East would be akin to forcing vegetarianism on everyone after Mad Cow disease.

The government doesn’t need to pick winners and losers in the energy markets. If officials want to “do something,” they should free up domestic production of energy and stop the regulatory crackdown on speculation in the financial markets.

Since the article reinforces our own points, it’s worth quoting extensively. In particular, note the differences between our current run-up in oil prices, versus the simple market-driven expansion in 2008:

Fatih Birol, Chief Economist of the International Energy Agency

Fatih Birol, chief economist at the Paris-based International Energy Agency…warned…that oil prices are expected to reach $100 per bbl. again soon, threatening the economic recovery…Birol warns that the rising price “is a wake-up call.”

But what exactly should we be waking up to this time? The 2008 price surge was explained by simple supply and demand: not enough oil was being pumped to meet the voracious appetite of Asian economies, particularly China and India, whose high-speed expansion oil suppliers had failed to anticipate. Today, however, there is enough spare oil warehoused, and demand remains relatively weak after two years of recession. Even if supplies tighten, some specialists believe that more oil could be brought to the surface fairly quickly. Saudi Arabia, the world’s biggest producer and the powerhouse of OPEC, which produces about 40% of the world’s oil, is pumping well below its capacity. And as international oil companies revamp Iraq’s giant fields after years of stagnation, growth in that country’s output in the next few years will boost global supplies. “There is space capacity in OPEC,” says Olivier Jakob, managing director of PetroMatrix, an energy-analysis firm in Switzerland. “The financial picture is very different from 2008.”

So if oil’s incredible surge—recall that crude prices have tripled since their trough in December 2008—isn’t to be explained by a recovery in the global economy, who or what is responsible? Back to the article:

The current spike in oil futures, say Birol and Jakob, is a product of excess supply — of speculative dollars, billions of which are flowing into U.S. commodities markets. “The investors are using their cards to their benefit,” Birol told TIME…”The way they’re reading the market, they feel that when the U.S. recovers, there will be a strong demand and a tightness” in oil supplies. Commodities investments in general have soared since August, when Federal Reserve Chairman Ben Bernanke announced the quantitative-easing program to boost the supply of investment capital. “Before the Fed announcement, net interest in crude oil was fairly neutral, but it has now climbed to the highest level ever,” says Jakob. “The U.S. Fed is injecting about a trillion dollars into the economy in six months, and that liquidity has to go somewhere. Some of it has gone into commodities.”

Although Birol’s comments are correct as far as they go, he is leaving out the element of investors using oil (and other commodities, especially gold) as a hedge against potentially high price inflation.

As we explained in our original post, in times of economic uncertainty—coupled with large bouts of new money-creation—investors aren’t sure where to turn. The stock market is risky, because of the weak economy which many fear could collapse again. But bonds are also are risky, in the eyes of investors who expect rising inflation and interest rates down the road. And the real estate market is hard to read as well, as it is on government life support.

In this environment, many flee to commodities as the least dangerous storehouse of “real” wealth. Markets are very complex, and of course there are millions of factors ultimately determining the price of crude oil. But surely Ben Bernanke’s injection of more than $1 trillion into the credit markets is playing a large role.