If you thought the subject of oil was a bit far afield for the steward of the nation’s money supply, think again. As Alan Greenspan rides into the sunset of his final months as head of the central bank he told the National Petrochemical and Refiners Association conference in San Antonio, Texas yesterday that market forces should be allowed to prevail when it comes to the price of oil.
“We must remember that the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion,” Greenspan said, according to FinFacts.com There’s also the issue of incentives with alternative energy sources and how that’s affected by oil’s going rate. Simply put, higher oil prices create stronger incentives to new options. Perhaps that’s obvious, but Alan reminded us anyway: “For years, long-term prospects for oil and gas prices appeared benign,” he explained. “The recent shift in expectations, however, has been substantial enough and persistent enough to bias business investment decisions in favor of energy cost reduction.”
And who could argue? Certainly no one who’s read and embraced the free-market principles laid out by Adam Smith in the 18th century. Indeed, oil prices are inextricably connected to supply and demand, and supply and demand dances the dance of a feed-back loop. If supply runs short and demand holds steady or rises, prices will rise; if prices rise far enough and fast enough, they curtail demand, which creates spare capacity. Rising spare capacity, in theory, will eventually lower prices. Round and round it goes. That, as they say, is what makes markets.
And since we’re praising the market, why don’t we check in with the oil traders. In the wake of the maestro’s energy comments, the price of crude in New York futures trading has closed lower for two days running. The impact of Greenspan’s rhetoric is apparently alive and well in his waning months as central banker in chief. But even as powerful and persuasive a voice as his has limits. Indeed, there’s only so much a Fed chairman can do when it comes to oil prices. In fact, the point where a central bank’s punch is most potent in the energy realm is found within the arcane art of monetary policy, and on that score there are some who find reason to fault Greenspan.
There is, after all, a closely entangled relationship between the price of a barrel of crude and the dollar. Oil is a global commodity that’s priced globally in dollars. That means that even a purchaser of oil who holds euros, yen or some other form of government paper is bound by the prevailing dollar exchange rate. As for dollar-based buyers of oil, forex may seem an irrelevancy, since oil’s priced in greenbacks, but that’s an erroneous assumption of no insignificant magnitude.
Consider the price changes in a barrel of crude (measured by the spot price on the New York Mercantile Exchange) in dollar terms vs. euro terms. Assuming a current price of $55 a barrel in the here and now, oil’s up more than 200% from December 2002, James Williams of WTRG Economics tells CS. Now the kicker: in euro terms, oil’s up 59% over that stretch.
That price differential is another way of saying that the dollar’s weakened relative to the euro. Indeed, the U.S. Dollar Index, which is based on the average exchange rates of six leading currencies in the world, has shed about 17% from the end of 2002 through today. Clearly, forex is an essential factor in the price of oil, a fact that raises more than a few questions about what the Fed is doing to maintain the integrity of the greenback. “The weakness of the dollar over the past couple of years has definitely been one of the significant component in crude prices,” WTRG’s Williams explains. In fact, he notes that the differential in oil pricing is growing wider over time in euros vs. dollars.
Mr. Greenspan can speak all he wants of supply and demand and the wisdom of markets. But at the end of the day, the most powerful tool at his disposal in the war to help the United States manage energy costs to the benefit of the American consumer is to do as much as possible to preserve the value of the buck. Of course, he should be doing no less even if oil was $10 a barrel. But to judge by recent trends in the formerly mighty buck, the maestro’s stumbled. Or has he? True, some if not most of the pressures on the dollar are beyond his control. The government’s fiscal deficit, to cite an obvious example, is a byproduct of Congress and the White House.
All the more reason for the Fed to do what it can to succeed within its relatively narrow purview of protecting the dollar. Even under the best of circumstances, the pressure on the dollar is immense courtesy of America’s large and growing appetite for imported oil. “We’re buying 10 million barrels a day,” notes Williams. “Every two days, $1 billion goes out of the U.S. to Mexico, Canada, Venezuela, Saudi Arabia, and others. A billion here and a billion there, and it adds up.”
The Fed can, of course, print an unlimited supply of dollars to fund its oil purchases, the fiscal and trade deficits, and any number of other tasks that can be solved with a few more George Washingtons. But while there’s no theoretical limit to running the government’s printing press, there’s a practical limit. We’re nowhere near that practical limit. Indeed, it’s unclear exactly where the boundary lies. But rest assured, we’re a lot closer than we were when oil was $30 a barrel.