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Monthly Discussion

The Price of Oil Revisited

More than once we have looked at oil prices in this Newsletter. We are going back to it once more not only because of the “small” public outcry against high oil prices, but also because I like going back confront my forecasts (not a popular practice among forecasters).

My thesis has been—as presented in Predictions—that primary energy answers to such a fundamental need of society that it becomes somewhat of a sacred cow and resists significant changes in its price. Just think of the resistance a country leader would encounter if he or she tried to double the price of bread across a country like India or China.

There have been notable exceptions of energy-price jumps, but they do not last for a long time and they seem to come in regular intervals, namely every 56 years (see Kondratieff Cycle). Last such outburst of primary-energy prices took place in 1981 with the oil crisis. The 56-year clock says that the next such hike should not be before the mid 2020s. And yet we have seen oil prices rise steadily recently breaking new records more often than not. In Exhibit 3 we see that the average price of crude during 2004 surpassed that of the crisis year 1981.

Exhibit 3. Yearly averages except for the 2005 data point, which consists of the average of only January and February. The data come from inflationdata.com.

One does not need to be an economist to argue that we must correct for inflation before we make such comparisons. So we do this in Exhibit 4 and things look less alarming. The average price during 2004 turns out to be only slightly higher than half of that during the famous crisis year 1981.

Exhibit 4. Inflation-adjusted (2004) yearly averages except for the 2005 data point, which consists of the average of only January and February. The data come from inflationdata.com.

I would have normally stopped my oil-price study at this point. But two things kept bothering me. First that the price level presently is at abnormally high levels, given that we are so far away from the next Kondratieff flare-up. Second that if this is indeed a real oil-price flare-up—and the Kondratieff cycle simply breaks down here—why has people’s reaction be so muted? Why haven’t we seen significant social concern manifested? Americans seem to be annoyed with the high oil prices, and outside America people are even less concerned.

Then I noticed that the rising price of oil coincides with the falling value of the dollar in world markets. The price of oil is by no means dictated by the United States and a rising price of oil with a declining dollar suggests some kind of price stability. So I considered the currency of a neutral, small but stable, country like Switzerland to look at oil prices. Exhibit 5 shows inflation-corrected oil prices in Swiss Francs and the rise of oil prices in the last year-and-a-half seems of the order of only 10% to 20%.

Exhibit 5. Inflation-adjusted yearly averages expressed in Swiss Francs. The 2005 data point consists of the average of only January and February.

According to Exhibit 5 the price of oil in early 2005 is a factor of 3 below the average oil price during the crisis year 1981. To see this better I have superimposed the data from Exhibit 5 onto Figure 8.3 from Predictions – 10 Years Later. The result is shown in Exhibit 6 below.

Exhibit 6. Figure 8.3 from Predictions – 10 Years Later updated here with the data from Exhibit 5. The little circle represents the oil price on March 10, 2005, namely $53.5. The yellow line has been adjusted to coincide with the oil price flare-up of 1981.

CONCLUSIONS

The rise in oil price during 2004 and early 2005 is by no means an alarming situation similar to that of the early 1980s. Most of the price rise comes from inflation and the diminishing value of the dollar. The inflation-corrected average oil price during 2004 was $37.7. This value is within what could be considered as “normal” in Exhibit 6.

Prices above $50 (today’s dollars) can be considered as “somewhat” high. I expect them to go back to the $40-$50 range before the end of the year. Alarmists arguing for $80 or $100 price tags have zero chance for seeing it, other than possibly for only … a day or two! All the same, watch out for inflation and further declines in the value of the dollar.