What to Make of Oil's Weakness

Not long after he was inaugurated as our 40th president, Ronald Reagan predicted a fall in the price of a barrel of oil. What made Reagan so confident?

Aware of the historical relationship between gold and oil, Reagan deduced that oil was due for a correction based on a 20% drop in the price of an ounce of gold since his election. Sure enough, by December of 1981 the price of a barrel of oil was nearly 20% lower than it had been one year before.

Looked at over a longer timeframe, from 1970 to 1981 the price of gold rose 1,219 percent, versus a rise in the price of oil 1,291 percent. This wasn’t coincidental. With gold and oil both priced in dollars, and with gold serving as the best proxy for the latter’s value, a jump in the gold price neatly foretold the oil “shocks” of the 1970s that were merely dollar shocks.

Given the strong price correlations between the two commodities, many economic commentators wrote of the gold/oil relationship in terms of a 15/1 ounce/barrel ratio. As the late Warren Brookes wrote in his 1982 book, The Economy In Mind, “In 1970 an ounce of gold ($35) would buy 15 barrels OPEC oil ($2.30/bbl). In May 1981 an ounce of gold ($480) still bought 15 barrels of Saudi oil ($32/bbl).

More modernly, in March of 1999 The Economist predicted $5/bbl oil in the future because “the world is awash with the stuff, and it is likely to remain so.” Instead, with the gold/oil ratio of roughly 25/1 historically out of whack, crude proceeded to rally beyond the 15/1 ratio; reaching $24/bbl by September of 2001.

Since 2001, gold has rallied powerfully owing to the dollar’s debasement over the same period. Unsurprisingly, oil has skyrocketed too. With many commentators on both sides of the political spectrum unfamiliar with the relationship between the dollar, gold and oil, apocalyptic notions of shortages and “limits to growth” have revealed themselves much as they did in the ‘70s.

More realistically, the oil “shocks” of this decade were rooted in dollar shocks that were bound to make oil dear in dollar terms. As of last month, oil since 2001 had risen over 380 percent in dollars versus 160 percent in euros. Though the numbers were different in the late ‘70s, this was not unlike oil’s 43 percent rise in dollars from 1975 to 1979; a “shock” that did not register in deutschemarks, yen and Swiss francs where oil rose 1 and 7 percent in deutschemarks and yen, versus a 7 percent fall in francs.

Last month, gold rose at one point to nearly $1,000/ounce, and oil hit an all-time high of $147/barrel. Since then, oil has fallen roughly 23 percent against a 17 percent drop in gold. So as is always the case, a large reason for oil’s current weakness has to do with a dollar that presently buys 1/827th of an ounce of gold, as opposed to nearly 1/1000th a month ago.

Still, oil has fallen further, and while rumblings of greater supply reaching the market due to presumption of liberalized drilling rules might explain some of the disparity, another realistic explanation lies in the aforementioned gold/oil ratio. As of last month, the ratio was roughly 6.8/1, so if history is any kind of indicator, oil was and is due for an even greater fall versus gold given the longstanding relationship between crude and the yellow metal. Looking ahead, no matter the direction of gold, oil has room for further weakness given a ratio that as of this writing is roughly 7.3/1.

What explains the dollar strength that has revealed itself in lower commodity prices? To some degree we can tie it to the coupled world economy that had never “decoupled” in the way so many pundits suggested. Simply put, dollar debasement regularly leads to world currency debasement, and with economies around the world struggling under the inflation that bats 1.000 when it comes to economic uncertainty, the severely weakened dollar has perhaps paradoxically been seen by investors as a safe haven in these treacherous times.

More interestingly, polls and market-based measures of political outcomes such as Tradesports.com point to a Barack Obama victory in November. Whatever his many policy faults, Obama recently met with strong-dollar advisors Paul Volcker and Robert Rubin, and not long after told a gathering of potential voters in Ohio that a strong dollar would help reduce the cost of fuel.

Obama’s new position dovetails nicely with a recent Forbes.com interview of McCain advisor, Douglas Holtz-Eakin. Holtz-Eakin talked up the value of a strong dollar, and this is very important for putting the dollar in play as a campaign issue. Looking past November, the markets are perhaps pricing in better dollar policy ahead, regardless of the winner of the presidential contest.

It’s also notable that Treasury Secretary Henry Paulson a few weeks back termed a strong dollar “very important.” The latter is a not insignificant improvement over his “the strong dollar is in our nation’s interest” comments that the markets understandably did not take seriously. Investors of course ignored Paulson’s boilerplate statements given the Bush administration’s anti-dollar stance that has revealed itself through a true policy of "benign" dollar neglect, tariffs on steel, lumber and shrimp, not to mention frequent jawboning of China over the value of the yuan.

If the long neglected dollar’s collapse is permanently reversed, look for lower commodity prices across the board. And while many commentators will say this is evidence of a weakening world economy, don’t be fooled.

Since 1971, all commodity “shocks” have been dollar shocks; the dollar’s debasement real inflation that has revealed itself through more expensive commodities and a weaker economic/investment outlook. Conversely, commodity weakness has regularly resulted from dollar strength that enhances the value of the money we earn, all the while leading to greater investment for inflation not destroying the returns gained from that same investment.

Put simply, the nascent bear market for commodities is a bullish economic turn for it signaling a resumption of dollar strength. If commodities continue to fall, this will be more evidence of better dollar policy that will occur alongside rising equity prices and a more economically confident electorate.