Two Reasons the Price of Crude Oil has Increased

What happened last week? Anything interesting?

We spent the weekend painting windows and doors, fixing the roof. Less is more, we realized...in houses as in dessert. As a place to live, our house in France is a disaster. As an investment it is a catastrophe...

But we'll have to wait until tomorrow to tell you about that...

Back to the latest financial news... The Saudis announced that they would consider increasing the amount of oil they pump. They said they could increase production by 200,000 barrels per day.

Watch out, dear reader...markets still work. The cure for high prices is high prices. High prices encourage producers to increase output...and consumers to reduce consumption. Sooner or later, the medicine does the trick - and price of crude oil fall. Oil closed Friday still near an all-time high, at $134 a barrel. While there may be more upside, the danger is on the downside.

Analysts are still wondering why the price of crude oil is so high. "Supply and demand," say the oil bulls. "Speculation," say the oil bears. "Oil company profiteering," say the politicians.

The good...the bad...and the ugly - you can get any opinion you want.

And in Byron King's opinion, the Saudi's aren't quite telling the truth:

"In 2004, Saudi officials claimed they boosted production to 9.5 million barrels per day and maintained that level for five months," says our intrepid correspondent.

"It's almost sure they were lying. The International Energy Agency is the group that keeps an eye on these things for the developed, oil- importing countries. The IEA could find no sign the Saudis were selling more oil.

"As far as anyone can tell, they pump only around 5 million barrels a day, and that's all they've pumped for years."

And that's just the tip of the iceberg.

But there are only two real reasons the price of crude oil has gone up. The first is that more people are using the stuff. And the new users are not the same as the old users. The old users - in the U.S.A. and Europe - are much more sensitive to price pressure than the new users. Incomes in America have been more or less stagnant for 30 years. When the price of gasoline goes up, people have to take money out of other household budgets in order to make it up - or, drive less. Currently, they're doing both.

But the new users live in places such as India, Russia, China, and Brazil. They can afford to use more energy, even with rising prices, because their own incomes are doubling every 7 to 10 years.

And it's not just energy prices they are pushing up. Emerging markets consumed 36% of the world's copper in 1998. Now, they take up 59%. And zinc, too; emerging markets use 63% of the world's output compared to 43% ten years ago. You can go down the list of commodities; the story is the same. The developed world has enough refrigerators and automobiles already. People just replace what they have. But in emerging markets...the scope for selling more appliances, houses, automobiles and the rest of the paraphernalia of modern life is wide open. In these countries, as soon as people get some money, they go out and buy a washing machine. And good for them. But it means that the market for the basic ingredients of the machine age is no longer controlled by Western consumers. And it means - for the first time ever - that even if Western economies go on the fritz, prices paid by Western households may still go up.

This is bad news for the average American household; it has so much debt it can't afford an increase in energy prices. And it's bad news for the industry that loaded the average American household up with debt. Since 2006, U.S. house prices are down 16%. That, of course, has thrown a lot of mortgaged-backed credits onto the trash heap. Banks and other financial institutions have already written off $350 billion of mortgage-backed loans. Another $300 billion or so in write-offs seems likely. But the whole U.S. banking system only has about $1.3 trillion in equity; so these amounts represent a considerable share of the banks' total capital...and a big blow to the whole industry.

Naturally, banks and brokers have been rushing to bring in more money. And they're scheduled to announce big dividend cuts this week, to preserve their cash. You'll recall, dear reader, that when the finance sector went down last fall, many investors thought they saw an opportunity to get in on flagship firms such as MBIA and Citigroup at bargain levels.

Alas, it didn't work out. As we keep saying, when a bubble explodes...there is no way to get air back in. You can pump, but the air goes into a new sector.

Which brings us to the second reason commodity prices have gone up: because the dollar and other paper currencies have gone down. Just look at the price of crude oil in terms of gold: Ten years ago, an ounce of gold bought as many as 26 barrels of oil. Today, it takes 13 times as many dollars to buy a barrel of oil as it did in 1998, but only about twice as much gold. Now, an ounce of gold buys 7 barrels of oil. By this measure, oil is either too expensive or gold is too cheap. Whether you measure it in dollars or in gold, oil is high. It's gone up 1300% in dollars, and 350% in terms of gold. But at least if you had traded your dollars for gold at $260 an ounce ten years ago, gasoline wouldn't seem so expensive.

So let's get back to the investors who decided that the bottom was in for the financial industry.

"Investors who backed U.S. financial companies' drive to raise much- needed capital are sitting on nearly $10 billion in paper losses," says today's Financial Times. Since last October, the finance business has raised some $64 billion of additional capital. That investment has dropped in value by $9.7 billion, reports the FT , giving investors a 15% loss.

Ambac, for example, raised $1.2 billion; investors who put in that money have lost 70% of their money since March. A similar amount invested in MBIA resulted in a 60% loss. Citigroup investments, meanwhile, are down 2$%.

Bill Bonner
The Daily Reckoning Australia

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