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Vicious cycle: Rising oil prices, falling dollar

This year's dramatic increase in oil prices and the decline in the dollar aren’t two unfolding crises for the U.S. economy but two sides of a single blockbuster problem.

And unless you understand the vicious cycle of higher oil prices leading to higher trade deficits leading to a weaker dollar leading to higher oil prices, you won’t see the changes coming in your everyday life until they hit you like a truck doing 60.

Let me try to explain the cycle and its consequences for the everyday economy where we live our lives.

Let’s start with higher oil prices. In the beginning, they were a result of several factors:

* Higher demand for oil from the fast-growing economies of China and India.

* Supply disruptions in Iraq, Nigeria, Venezuela, Russia and the U.S. Gulf Coast.

* Fear that the global oil industry was finding less and less new oil.

* A terrorism/war premium.

* Buying by traders speculating that oil prices would rise.

Under the pressure of all those circumstances, the price of a barrel of oil in the U.S. climbed to a high near $55 a barrel this year. That’s a huge increase, considering that the average benchmark price of a barrel was just $21.84 in 2001, and it pushed the cost of U.S. oil and gas imports higher and higher. In October, the Labor Department reported, the $12.3 billion cost of petroleum imports was up a huge 68% from October 2003.

Pricier oil equals higher trade deficits

Because we import so much of the oil we use, the huge jump in petroleum prices has added to the growing U.S. trade deficit in goods and services with the rest of the world. That deficit -- the difference between the cost of what we import and what we export --climbed to $51.6 billion in September 2004. Contrast that with the $29.6 billion monthly U.S. trade deficit in January 2002, before the price of oil spiked.

That deficit can’t be blamed wholly on the rising price of oil or on U.S. oil imports in general, but the petroleum-related part of the deficit is now so large that it just about guarantees rising oil prices in the future. And that’s because oil is priced in U.S. dollars, and the fall of the value of the dollar has led to a decline in the value of the dollars that the Organization of Petroleum Exporting Countries collects for its oil.

Think about being the executive of a Saudi oil company that wants to buy equipment from France’s Schlumberger Limited (SLB, news, msgs). Thanks to the fall in the dollar against the euro, that equipment costs 10% more in dollars on Dec. 8, 2004, than it did a year earlier. And if you go back further to the dollar’s high against the euro in 2002, that oil equipment priced in euros now costs 57% more than it did in 2002. (The euro zone countries represent the biggest source of OPEC imports, so the exchange rate between U.S. dollars and euros is critical to OPEC finances.)

No wonder OPEC is so intent on raising its target price to $30, a huge increase from the current target of $22 to $28 a barrel, as it was expected to do at its meeting today, Dec. 10.

Welcome to the vicious cycle

And this is where the vicious cycle kicks in. Every dollar increase in the price of a barrel of imported oil increases the size of the U.S. trade deficit, which puts more pressure on the value of the U.S. dollar, which leads to a weaker dollar, which makes OPEC countries want to raise the dollar-denominated price of a barrel of oil to make up for the dollar’s fall, and so on.

A vicious cycle, like its self-reinforcing good counterpart the virtuous cycle, doesn’t reverse overnight. Ending this one will require a drop in U.S. energy imports sufficient to decrease the U.S. energy bill, thereby shrinking the U.S. trade deficit and decreasing the supply of dollars sloshing around OPEC. (A little fiscal discipline on the part of the U.S. government, a revaluation of the Chinese yuan and a pickup in global growth so that overseas consumers could buy more cheap U.S. exports wouldn’t hurt, either.)

Energy efficiency helps -- over the long haul

The United States pulled off exactly this kind of energy play beginning in the 1970s. Faced with two rounds of energy price shocks, the U.S. economy doubled its energy efficiency between 1975 and 2004. A similar doubling of efficiency is certainly possible. (If you want to see how, go to the Winning the Oil Endgame Web site.)

But notice that we’re not talking about a quick fix so much as a process that plays out over years.

Figuring out what stocks to buy for this kind of vicious long-term dollar/energy cycle is actually pretty easy. I’ve written about what to own in past columns and I’ll tackle the subject again in my next column.

But figuring out how this will change your day-to-day life and what to do about it is harder. Especially because short-term price swings, like the $12 or so drop in the price of a barrel of oil in recent weeks, can disguise the long-term trend. I’m sure that some people who were worried about gas prices in October are now convinced the crisis is over since the average national price for all grades of gas dropped to $1.96 in December, according to the Lundberg Survey, down 11 cents a gallon since Oct. 22. Well, nothing in these price declines has yet broken the long-term upward trend. So let me give you a few candidates for change as we adjust our way to an end of this cycle.

1. Expect higher prices for imported goods from strong-currency countries. We haven’t seen much effect on prices from the weaker dollar yet because overseas producers have been absorbing the price increases caused by the weak dollar in an effort to keep U.S. market share. But there’s only so much punishment that any company’s margin can take. Some currency traders on Wall Street are predicting that the euro will go to $1.45 or even $1.60 by the end of 2005. That would be a further 8% to 19% rise in the euro from the high so far this year. (Do remember that these Wall Street currency experts are usually currency traders speculating on the direction of the euro and the dollar. They wouldn’t ever try to drive the market by making self-serving projections, of course.) The solution to this is conscious and disciplined substitution of domestic products -- or those from dollar-pegged countries like China, Argentina and Costa Rica -- for higher priced imported goods.

2. Expect high and rising energy costs for a long time. Breaking this vicious cycle could take a decade -- longer if our government continues to ignore the problem, and much longer if the experts who project that we’ve reached the point of diminishing returns in new oil and gas discoveries are right. This period will be painful, but the length of the period and the likely magnitude of price increases mean that structural investments in saving energy will have enough time to pay off for individuals. Investments can range from a new, more energy-efficient air conditioner to new solar-glazed windows to solar water-heating systems.

3. Expect that trade-offs made in recent years will look wrong in the decade ahead. For example, many of us traded longer commutes for cheaper real estate. With every penny rise at the pump, that trade-off will feel a little worse. No need to kick yourself, though. You acted on the best information the economy was sending you at the time, and many of us couldn’t afford to buy a house closer to work or play or relatives or whatever. You can make the trade-off work out even in a changed economy, however. For example, offset the higher price of gas for your commute by adding insulation to your attic to reduce your heating bill.

4. Expect a reshuffling of real estate values, especially for vacation homes. It’s a good bet that fewer Americans will be traveling to Europe as the dollar weakens, and that will put a premium on vacations in the United States. The most attractive destinations will be those that don’t require long, energy-intensive travel. That remote hideaway just a five-hour drive (or flight) away isn't going to seem quite as wonderful as gas prices creep upward. Vacation areas within an easy drive of home will command a premium.

5. Expect interest rates to keep climbing. The Federal Reserve says it’s not worried about the weak dollar, and that’s actually true, as long as the dollar’s decline stays gradual. But if the decline turns into a rout, expect the central bank to prop up the greenback with higher interest rates. (Couldn’t be that the Federal Reserve is already doing just that, could it, despite its rhetoric of unconcern? Nah, of course not.) You’ve got time to get your financial house in order, but you need to start today to reduce your debt load. (To learn how, see recent columns on saving by me, "Successful investing starts with saving," and Liz Pulliam Weston, "10 easy ways to stash away thousands.") Start with any adjustable-rate debt and pay extra attention to making payments on time for all your debt, so that no lender can ratchet up your interest rate.

6. Expect an increase in taxes to support the dollar. Mind you, I’m not predicting any conversion to fiscal rationality by any part of government. Instead, we'll see a tax hike based on a recognition that a weak U.S. dollar limits our ability to influence events in the world and to project military and economic strength. Except on the grade-school playground, it’s hard to push people around when you owe them money.

I know that the picture I’ve sketched here isn’t pleasant. Frankly, I find it pretty depressing myself. But I find that it helps, emotionally, to realize that we’ve been through periods like this before and they haven’t meant the end of life as we know it. (And they often produce great collectibles: I still have my Whip Inflation Now! button.) And I truly believe that planning ahead will make the difference during the next decade between suffering as a victim and enjoying life.

What do you think? Leave a comment below.

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