More Reasons Why Oil Prices are Going Up

For all of you “oil price equals inflation” enthusiasts, watch what happens with Japan’s nuclear power industry. Reports are that after April of 2012 Japan will have no working reactors. They will have all shut down permanently for various, mostly irrational, reasons. To still provide power, Japan will have to import fossil fuel, oil, to the tune of about $30 B a year. Think that won’t have some impact on international oil prices?

Coal fired power plants in the U.S. are expected to be shut down over the next few years because of environmental regulations. Where that power will come from is not clear as far as I can see, at least publicly, but oil may play some role (I would like to hear form someone with accurate information).

Those people in the U.S. who are losing their coal-fired power plants will see a double attack on their standard of living. Not only will their electric bills go up by an estimated 40% to 60%, but their bill for fuel for their car will stay high or also go higher. Who will they blame?

In other words, for various reasons, mostly having to do with government regulations, we are going to see a necessarily higher demand for oil over the next few years. If the large developing nations, especially China (I have written about China’s potential difficulties, so its oil demand is not a sure thing.), continue to demand more oil, and the nations of the world continue to restrict the oil industry’s attempts to find, develop, and produce from oil exploration (government owned “oil companies” are not competent to fill this need), we will see oil prices stay high, very high. As of this writing, oil prices are about $90 a barrel for light crude. (The price is lower than it was because a few countries, including the US, released oil from reserves. This is a short-term bandaide and will only mask the problem until they stop releasing oil or can’t release any more. No one is moving to free the oil companies.) If China continues its present demand level, we can expect to see oil prices rise. If China has economic problems (as I think it will) then oil prices will merely stay near their present levels as all of these regulations and irrationalities play out.

INFLATION PRIMER

More and more people are getting on the inflation and hyperinflation bandwagons lately. There may be reason to worry about inflation, several, in fact. But, for the most part, the reasons that are being offered for today’s bandwagon do not justify the conclusions that people are making.

My position is this: Real inflation is a major cause of economic disturbance and the destruction of economic value. Inflation needs to be eradicated from our lives and our political system. To remove inflation from our economy would require that we understand it at it’s root and have an accurate history of its influence. Instead, what these people tend to offer is just pointing at some prices that have risen that are special to us or in the news. Even when they mouth reference to the money supply, they do nothing to relate the money supply to the price increases they are seeing. They are just adding confusion. So, I am offering another post about inflation with a slightly different focus.

First, of course, rising prices is not inflation. Rising consumer prices may be a consequence of inflation, one of them, but it is only a consequence, not a cause, and it is the cause that we want to understand clearly. It is the cause that is the actual problem. It is the cause we need to eradicate from the economy.

The Austrians (and as further explained and expanded by Ayn Rand) are the ones who identified inflation accurately. Inflation is government manipulation, read expansion, of the money supply. When more money is pushed into the economy, prices, at least some prices, will rise. There are two important points.

First, prices cannot rise without there being more, new, made-up money. Without more money, some higher prices would just mean that fewer of those products could be sold. People would still have only so many dollars to spend. Higher prices for some goods means that the standard decisions people make as to what to buy and not buy must now account for a different price structure than before. Prices are always changing. All prices could not be rising at the same time without there being more money in circulation. Stuff would be left sitting on the shelves. Consequently, if some prices rise, other prices would have to drop, or production would have to be reduced. There are only so many dollars.

Some people try to avoid the basic physics of the issue by talking about the velocity of money, suggesting that if a unit of currency changes hands faster there is the opportunity for prices to rise without more money actually being created. No attempted explanation of inflation using the velocity of money that I have seen actually lays out how that is suppose to work. I can’t figure it out. Try it. The vast majority of people get paid on a regular rotation, i.e., weekly, biweekly, or semi-monthly. How do you fit a higher velocity into that arrangement? You can’t. Higher velocity is out.

Second, the Austrians determined that the entry point for new money makes a difference, meaning that new money does not effect the entire economy the same way, but ripples out from the point of entry. Over the past twenty plus years, the entry points for new money have been limited to just a few parts of the economy. It is easy to identify those connected directly to the Federal Budget because the prices of related items have been going up rapidly and consistently for all of those years. The list connected to Federal Government spending includes medical services and related products and higher education. Recently, Federal employee salaries can be added to that list.

Besides the budget, the other main entry point of new money is by way of the activities of the Federal Reserve System. I have gone into detail how that happens in this blog, so I am not going to restate it. The consequences of the Fed expansion of the money supply normally hit asset prices first. Stock prices and housing prices are pushed by the expansion of the money supply by the Fed – sound familiar? (Constant deficits in our Balance of Payments can also only be explained by the expansion of credit.)

Okay, so that is inflation, i.e., increases in the money supply. Well, take a look. Is the money supply expanding? Ahhhh, no. It isn’t. So where is this inflation?

What the people who are declaring that inflation is upon us are pointing to are certain, specific prices. Right now the major ones are oil, food, and commodities. Certainly, these prices are going up. But, is it inflation?

I would add another sector to the list of higher prices, the U.S. stock market, which has gone up a bunch in the last couple of years. Why has it gone up? The facts about the U.S. economy don’t support that kind of optimism. The actions of the U.S. government continue to make things worse. The market is being pulled along by a ton of money sitting around. It is the same thing that happened in the late-1990’s and mid-2000’s.

So what about the prices of oil, food, and commodities. Okay. Fact one. In any economy (where individuals can make decisions at least to some extent), in any situation, for all kinds of reasons, prices will be on the move. Some prices will go up, some will go down. We do see prices going down all of the time in our world. That is especially true of high tech stuff. Prices change because people’s preferences change. Demand changes. The supply changes because of new technology, new business structure, new sources, governmental action. There are a host of different reasons. You have to look at specific industries to understand the price movements. More than that, if it is inflation that is causing consumer prices to rise, the general trend would affect the entire economy, in a ripple effect. When the price rises are confined to specific sectors of the economy, it is necessary to look closely to determine what is happening. In is not proper to just declare that it is inflation. Looking closely at medical services, oil, and commodities results in very different conclusions for each sector. That is especially true when the best data available on the money supply (admittedly government data, but not sufficiently corrupt) show that the money supply is not expanding to speak of and credit has contracted.

I have already discussed the constant rise in the prices of medical services, which is a direct consequence of government spending. Let’s try oil. The price of oil is an international price. For its price rises to be a consequence of inflation, it would be necessary for there to be inflation of significant amounts in many countries. But, there are more obvious and immediate explanations as to why the price of oil has gone up, and may continue to rise. Two explanations, actually. First, as a result of the anti-industrial movement (which includes the ecology movement), the production of oil has been forcefully reduced nearly worldwide. In a few countries, the production is kept lower than those countries are capable of for the reason of attempting to influence the price (OPEC, of course). We all know that the supply of oil is less than a free market is capable of providing. Second, we have a couple large countries, very large countries, that have finally begun to open their economies up sufficiently that they have produced a modicum of wealth. These countries are now also buying oil in larger quantities than they have in the past. Just a little increase from these very large countries has a significant impact on the price of oil. So, we have a supply that is less than possible and a significant increase in demand, and, surprise, oil prices rise. Standard stuff. Inflation is not necessary to explain the price of oil. To the extent that there is inflation, the increase in the price of oil will be worse. If a specific country has inflation, its currency will tend to buy less internationally over time, and the price of oil in that country will rise faster.

The second half of the analysis of the oil price applies to commodities, including food. There is more international demand. Higher demand means higher prices for basic, auction-derived prices such as commodities. China and India are buying more than they did a few years ago. If there is the possibility of greater production, the higher prices will attract more supply and the price may go down, but that does not happen overnight.

Food prices, especially within a large country like the U.S., is more dependent on local factors. I have not seen sufficient reports to make a well-founded conclusion as to why prices have begun to move upward. International grain prices have moved upward, but really have only a minor impact on the prices of consumer goods in the U.S. The cost of wheat in a loaf of bread in the U.S. is only a small fraction of the price at the store. Transportation, i.e., oil prices might be more important. Weather is important. The important point is that the factors causing our food prices to rise are not an increase in the money supply and are somewhat different that the reasons why oil and other prices are rising.

Then there is the issue of inflation here vs. inflation there, in the present day case: inflation the US vs. inflation in China. China is experiencing inflation, both asset and consumer price inflation. It is also experiencing sufficient growth that allows people and businesses to buy basic materials on the world market that they couldn’t before. Both of these factors make up the fact that China is a major reason why international prices are increasing. To fully understand what the impact of China’s rise (as well as India’s) means, it is necessary, as always, to gain perspective. Don’t just focus on selected markets that fit with a particular expectation or world-view. Look at the big picture.

What is my suggested perspective maker? French wine! The prices of good French wine have gone through the roof, up maybe as much as 3 or 4 times what they were a couple years ago. The reason is that a very small percentage of China’s 2,000,000,000 people have discovered the good stuff and have the money to start buying. They have bid up the prices. The Chinese are bidding up the prices of many things right now. The world has been rolling along with a few industrial countries and a lot of undeveloped ones as the status quo. Imagine the situation if many countries were to open up their economies to individual efforts and wealth. The demand for basic commodities would skyrocket! The old, restricted level of production would not be able to respond, shortages would ensue, and prices would rise. That scenario is pretty much what we are seeing. Newly freed countries would mean periods of economic adjustment as changes in distribution patterns developed. Ultimately, either we would see greater production, and thus higher standards of living all around, or we would see massive shortages and breakdowns in the world economy. In this respect, the emergence of China and India as economic powers will be good for all of us. Countries that refuse to deregulate, like the Europeans are blindly doing, will be faced with falling standards of living and fiscal nightmares, as is happening. For those who have tied their thinking to the dominance of the U.S. in the world economy, there will be confusion. In a world that is free and prosperous, the U.S. would be a great competitor, but not the richest nation. It is not the biggest country. But it would be incomparably richer than it is now. Higher productivity and creativity worldwide would mean greater wealth for all, and we would benefit.

But, back to the point of this post, greater demand for commodities, or anything, and subsequent rises in prices is not inflation. Only increases in the money supply by government action is inflation. Keep your causes straight.

Inflation and the International Wheat Market

One site that I monitor that discusses inflation is loudly trumpeting the recent rise in wheat prices as proof of their longstanding belief that we will be seeing lots of inflation, and future hyperinflation. They have forgotten or did not know that inflation is a domestic issue, revolving around a nation’s currency, that price inflation is a rising of the general price level, and that many different things can cause a specific product’s price to change, even without regard to any government activities. They also do not seem to understand the importance of looking at the context of the facts of reality, in this case the international wheat market.



Before looking at the wheat market, I want to emphasize that there is no free market in the world. All markets, including international markets, are affected by individual nation’s attempts to manipulate their own domestic currencies and product markets. Nearly all nations today are manipulating domestic markets directly or indirectly with little restraint. International markets are the total sum of the actions of each nation, plus the actions of individuals and associations of individuals (companies) both to meet normal business objectives and to avoid government restrictions. Whenever international markets are discussed today, these basics must be remembered. If someone talks as if markets were free of interference, we know that they are missing, ignoring, or evading current conditions. It is true that international markets do act independently of any one nation and that the controllers of a nation’s economy are often unhappy with what happens in different world markets. But the markets themselves are fundamentally affected by the actions of different governments, which often overcome real, purely economic or business factors.


Occasionally, and maybe surprisingly within today's context, a market will move as a result of events, real events, not government activity. That is what has happened in the world wheat market. Interestingly, the Russian economy after communism (notice I didn’t call it “capitalistic”) has turned its production of wheat into an export crop. Before, under the communists, Russia had to import wheat, in spite of its very fertile agricultural regions. Russia, as a mixed economy has managed to become a major exporter of wheat. Even so, Russia is not an advanced economy, not even where agriculture is concerned, so that it is more vulnerable to “mother nature”. Russia is suffering from a major draught (see news stories about fires around Moscow, too). Its wheat production has fallen dramatically (the Russian government has now banned wheat exports), and the world price for wheat has risen as supply has fallen, as you would expect.


A rise in a commodity’s price due to a shortage is not inflation. Certainly, if there is inflation, the situation would be worse, which is true today in nearly every country, but they are still two different things. Someone who doesn’t notice the difference does not understand the issues or the economy.


The price of oil is similar to that of wheat, with some additional provisos. The effects upon the international oil market of the actions of individual governments are more obvious, to anyone who looks, that is. The most important result of government action on the oil market is that of reducing the supply of oil, enforced shortage. Governments in many nations have restricted the search for and the recovery of oil. Further, many oil rich nations do not allow private companies to operate in their country, so their search for oil and its production is generally less competent and less successful.


If you have read my earlier posts you will have seen that I have been expecting oil prices to rise to close or above the prices from earlier this decade. The basis of my expectations were that the reasons why the prices was above $100 a barrel would exist again, i.e., increasing demand from the two largest populated countries in the world, India and China. Chinese demand for oil has resumed. India doesn’t seem to be as strong as it was, however. What we have seen is a price that has gone up, but still is significantly lower than it was earlier this decade. I think that the lower price is due to lower demand in the U.S., and probably Europe as well, due to the fact that neither area has recovered from the 2008 recession. Neither area is poised to actually recover, so for the immediate future, we can expect world oil prices to remain lower than the earlier highs. This may be true even though U.S. production of oil is bound to be further constrained by the backlash from the Gulf of Mexico oil spill.


To further my point in this post, oil price increases are not necessarily the result of inflation, either. International oil prices are going to be generally impacted more by direct manipulation by each countries domestic controls. There are so many examples besides the obvious restrictions on drilling and refining, which predominate in the U.S. Most of Europe has taxes on gasoline that make it very expensive, thus cutting demand. Some countries subsidize gasoline sales to consumers, increasing demand. Many of the oil rich countries have nationalized oil ownership and production. It would be interesting to research Indian and Chinese government policies regarding the discovery of oil reserves, production of petroleum products, and the importation and distribution of oil and gasoline. Regardless of those policies, both countries currently require significant importation of oil to support their growing economies, and their increasing requirements will tend to push international prices up. Which is not inflation. An investor, in a fairly rational context, would look upon the emergence of large economies that were actually developing as opportunities for enormous profit.


To that let me add a note regarding commodities in general. I want to talk about the basic stuff of production, i.e., metals, not foodstuffs. Consider a world in which all economies, all countries, were becoming capitalists. The initial supply of the basic materials of production would be stressed to meet the demand of newly productive economies. New mines and processing facilities would be competing for investment funds. Initially, prices for these materials would increase and products worldwide would become more expensive. This would continue for a while because the new mines would be producing material that was harder to extract and more expensive to mine or process. Over time, new mining and processing technology would be discovered which would tend to reduce the cost. Some of the upward pressure on commodity prices is happening now with the emergence of more productive economies. There are opportunities both in the short-run and longer term for investment, profit, and creativity.

Inflation Watch Update

These are some thoughts and observations about inflation: the prospect and what we are seeing specifically in prices.

As a reminder: inflation refers to the money supply
I use the term “price inflation” to talk about prices and the cost of living.

I saw someone saying that the price for small things like candy, fruit juice, stuff for less than a dollar or so, has gone up significantly in the past year or two. I don’t spend money on these things and don’t have a perspective. It would be interesting to hear form some people and their experiences of recent price changes.

I have also seen reports that segments of our produce production have been wiped out by weather. While this might have an impact on prices, it is not inflation and would be remedied by imports and the next harvest. It is important to keep a perspective on what is caused by government manipulation and what is caused by natural or market forces. Another example is oil or gasoline prices. The oil market is also heavily regulated and constricted domestically and in many other countries, which would tend to push the prices up due to shortages. A rising oil price due to government imposed shortages is not inflation or price inflation, however.

At the same time, housing prices and markets have been held up artificially over the last several months, which means that housing prices still have a ways to fall. If you are contemplating selling, do it soon.

Unfortunately, many, if not all, of the people who are arguing that significant price inflation is coming are very strident and projecting very extreme scenarios. Perhaps it is the result of the apparent indifference or ignorance of the American people. Maybe it is because of the propaganda emanating from the Fed, the Treasury, and the administration. Whatever, the stridency has a tendency to either make people anxious or drive them away. I am trying to offer a reasonable discussion and inference.

The major problem that is presented in looking into the economic future is the timing. In generally good conditions, you have considerable uncertainty mainly because of the multiplicity of actors and their perchance of doing things you don’t expect, usually good things, but still things different than you expected, so your decisions do not pan out.

In this situation, you know that what the government is doing is not good and will have adverse consequences. In fact there have already been adverse consequences, really bad ones. What you don’t know is how much worse the situation can get and when.

Price inflation can come at us from many different directions. We can see the dollars overseas come storming back, which would increase the circulating money enormously. (This is a favorite scenario of the scare mongers.) The Fed might try to stop or reverse the potential of price inflation by increasing interest rates, in which case we would see a business slow down and possible a reduction in availability of goods, while the money supply continued to go up, and we have price inflation during a recession, the 70’ again.

In a few years we will see inflation when the baby-boomers hit Social Security and Medicare, especially if their retirement funds continue to be wiped out.

We will see price inflation as Obama continues to spend money and the Fed accommodates him by buying the debt and pump money directly into the economy and keeping interest rates low. (This is actually not as bad as what they normally do which is expand bank credit, which has a multiplier effect.)

In other words, with all the money that the Fed is creating and will create, it is nearly impossible that price inflation won’t descend upon us. The ground has been laid for general inflation, i.e., the expansion of bank credit and thus many different messes, including price inflation.

Right now the banks have unlimited opportunity to make loans. There is plenty of demand and their Fed reserves are 10 times what they need. Bankers, however, are businessmen, government controlled businessmen, but still profit driven. They are conservative, cautious, and frightened by the mortgage crisis. They do not want to be taken over by the government. So they aren’t lending right now. Haven’t been for maybe a year or more.

You can see the problem of a lack of credit available in many of the business failures and the coming wave of commercial real estate foreclosures. Further, the Fed is trying to keep them from loaning out the money by giving the banks interest payments for the money in their reserves. I don’t really understand the reasoning here. Why did they give them the reserves only to pay interest on them to keep the banks from using it. Doesn’t make sense to me.

What the banks are really waiting for is the rebuilding of their capital structures (and for the banks forced to take government money, they are waiting until they can also pay that money back). Once their capital structures are in place, they will look for very secure, “safe” opportunities to loan money. We are not likely to see any asset bubbles soon. (Some say that the recent, rapid rise in the gold price is a bubble, but that is only true if it were financed by Fed created credit, for which I have seen no evidence.)

The Fed says that it will be able to soak up the excess reserves before it becomes a problem. Ha! Who can believe them. They will not own up to creating the last two asset bubbles (for starters). They won’t own up to what inflation really is. They are self-deluding. They think low interest rates are vital to a growing economy. They will also be pressured to keep interest rates low to support Obama’s spending plans. They will also want to keep interest rates low to keep the interest payments on the national debt from swamping the budget. The way they keep interest rates low is by creating bank credit. Increased bank credit is inflation. There is no way that the Fed is going to manage this mess without real inflation that will reach consumer prices. You can’t fault the hyper-inflation bugs. Any serious look at the situation has got to make you frightened!

So, what is going to happen. Here is where I find a limb to go out on.

Things are going to drift for a while. It may seem like the economy is going to recover, and it will in important ways. This is one problem with some of those who are expecting the worst, they do not give the American economy any credit. The American economy has a lot of strength and productive capability which is trying to dig its way out of the mess the government created. It is cutting costs where it can and looking for ways to become more productive, to carry the new burden placed upon it, just as it has done for years. Businesses are beginning to show profits, real ones. Unemployment seems to have reached its peak. I don’t think that the credit situation has worked its way out of its problems and that could cause a problem. If the Fed comes running in with more made up money, we could go back into recession. Things are touchy.

The banks are continuing to recover and build their reserves. The banks are, I think, the weak link, because in spite of their business orientation, they are creatures of the government. They have to be, with all the regulations and interference from the government. Some people complain that the regulators and the banks have become too buddy-buddy. The critics don’t understand that everyone in that community understands who is in control. It isn’t the bankers. So when the banks recover, they will try to do as their masters want, and open the credit window. It will start slowly at first, but over time, probably not a long time, the bankers will be back to lending profusely. Then it will be Katy bar the door, because the money, created money, will flow.

Sometime within the next two to five years we will be seeing significant price rises. This is my expectation now. I don’t feel as if I am being overly pessimistic, just as reasonable as I can be.

In a wider perspective of preparedness, I also think that oil prices will still have some upwards pressure. Commodity oil prices have gone up to the $70 range in spite of the worldwide recession. If the recovery is beginning why wouldn’t there be more demand for gas and other oil products? The supply has not grown in any significant way. Also, it was noticed this week that China is now buying more cars than the U.S. Isn’t that a demand for oil? Oil futures are showing higher prices.

I would say that we have some time to make some preparation, if you haven’t already. Don’t go overboard. You want to consider gold and dollar protection, as well as where profits might lurk, both short and long-term.

So, there is lots to consider in making your own plans. Just don’t expect the end of civilization, not based upon today’s information.

On the other hand, who knows what Obama’s supporters will do when it is obvious that his efforts are to no avail? They could riot and destroy everything in their path. They are the next storm troopers, just waiting for their opportunities. See, it is easy to expect the end of civilization!

More on inflation as I actually have something to add.
I have comments on gold, the dollar, and the Fed’s actions coming.