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The peak oil crisis: the year of the dollar

Our peak oil crisis is morphing into a dollar crisis. Despite record inventories, and millions of barrels sitting in anchored tankers, oil prices continue to rise. Earlier this week the average price of gasoline rose to $3 in California and many are predicting that the rest of us will be seeing $3 gasoline later this year.

While analysts are moaning that $70 oil is not justified by supply and demand, it seems that oil has become a favored store of value as massive US deficits eat away at the value of the dollar. The dollar goes down; oil goes up. For now there is so much excess capacity that geopolitical developments, stockpile reports and run-of-the-mill oil news has only a minor effect on oil prices.

Much of the recent run up in prices was based on this spring’s “green shoots rally,” in which many professed to see signs that the recession would soon be over, and that increased demand would send oil prices ever higher. The rally, which had its origins in a change in accounting standards allowing insolvent banks to pretend they were doing well for a while longer, seems to be slowing and may be coming to a close.

While the psychology of the equity markets is in a world of its own, most analysts, who don’t draw a paycheck from the financial services industry, are saying that the tough times are only beginning. Some who have studied the Great Depression are talking of a downturn lasting a decade or more. Should this sentiment become widespread and the equity markets start to move down again, it is an open question as to what happens to oil prices. Can a falling dollar offset reduced prospects for oil consumption from faltering economies?

The underlying cause for the dollar’s weakness is the massive deficit the U.S. government is running, and the continuing sale of billions of dollars worth of treasury securities. This in turn has left foreign investors worried that the value of their U.S. treasury holdings will one day be worth much less than they invested. For the foreseeable future, these investors have nowhere else to turn, for the minute they stop buying or try to sell significant quantities of U.S. obligations, they would immediately crash the dollar and their worst fears would be realized.

For now, China, Russia and other large holders of U.S. treasury securities are trying to make the best of a bad situation. They are talking among themselves about how they might transition to a new world reserve currency and are slowly reducing purchases of additional U.S. treasury securities.

For the immediate future, Washington has little choice other than to issue unprecedented amounts of debt. Although the administration assures us it will start cutting the deficit someday, this is tied to an improved economic situation that seems problematic. Despite massive intervention and purchase of treasury securities by the Federal Reserve, U.S. interest rates are already moving up, with the rate on the average 30-year mortgage loan increasing from 4.86 to 5.59 percent in the last few weeks, thereby choking off much refinancing and some new loans. Another couple of jumps like this, and the U.S. real estate industry will be having a lot more trouble.

If the U.S. dollar continues to fall, there is reason to believe that increasing amounts of oil will be purchased as a hedge and that the price of oil will continue to rise. The increase in oil prices does not have to be as fast, nor go as high as it did last year to create serious economic problems. The U.S. economy is in worse shape than it was 18 months ago, and is far more susceptible to the damage that would be wrought by sustained exposure to $3 or $4 gasoline. Every 10-cent increase in the price of gasoline takes $40 million dollars a day away from other consumer purchases. The increase in gasoline prices over the last six months is now draining an additional $400 million a day from consumers’ pockets. For every cent gasoline prices increase, sales of something else go down by $4 million dollars each day.

As strange as it may seem, the peak oil crisis, which has been focused on geologic constraints to oil production, supply and demand, geopolitical threats and inadequate investment, seems to be morphing into an issue of how much debt the U.S. Treasury can sell and still keep interest rates under control.

We can be certain that the U.S. Congress and government will not stand by and watch oil price increases driven by a falling dollar wreck the economy. As we saw last summer, there will be calls to break the dollar’s link to oil by restricting or even banning speculation. How well this will work in a globalized world is anybody’s guess. Unless there is worldwide agreement, activities banned in the U.S. could continue in Europe, the Middle East or Asia.

The more traditional constraints on world oil production – geologic, geopolitical and inadequate investment – are likely to come into play within the next three or four years, no matter the course of the current recession. Right now there is a surplus of production capacity, and indeed, already produced oil which is sitting around looking for consumers. If for one reason or another the recession deepens over the next year or so, then these surpluses are likely to grow.

It would be a great irony if oil prices were to continue increasing in the midst of substantial surpluses and falling demand.

Tom Whipple is a retired government analyst and has been following the peak oil issue for several years.

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