Don't Buy Brown and Sarkozy's Oil 'Speculations'

In the Wall Street Journal last week, French president Nicolas Sarkozy teamed up with U.K. Prime Minister Gordon Brown on a piece meant to reduce oil-price volatility. Given their shared view that oil volatility "damages both consumers and producers", they have called upon the International Organization of Securities Regulators "to consider improving transparency and supervision of the oil futures markets in order to reduce damaging speculation."

Sadly, for those around the world reliant on stable oil prices, their alleged solutions completely miss the point. And they'll do nothing to reduce substantial volatility when it comes to the price of oil.

For one, implicit in their argument is the logical impossibility that traders engaging in "excessive speculation" can somehow move the market for anything. What they ignore is the basic truth that there are two sides to every trade. In order for traders to speculate on oil in any direction, there must be an individual on the other side of each trade who assumes the exact opposite. Put simply, if there's "excessive speculation" that the price of oil will rise, there's an equal amount of speculation that oil's price will fall.

If we assume the impossible, that a collection of traders or speculators can control the price of oil in ways that OPEC (despite gargantuan amounts of money at its members' disposal) never could, we must then ask what explains the stupendous drop in crude over the past year. Last July oil hit an all time high of $145, but by the fall it fell to modern lows of $33/barrel. Were the alleged speculators simply feeling generous at the time?

And with the price of oil back up to roughly $60/barrel, are we now to assume that "greedy" speculators have decided to increase crude's price just a bit? Will they adjust it downward closer to Christmas with the health of "consumers and producers" in mind?

The very idea is laughable, but in a policy environment like today's where the notion of government "stimulus" is actually taken seriously by politicians and economic experts alike, anything's possible.  Indeed, to read Brown and Sarkozy's op-ed is to understand more clearly why world markets are so uncertain.  They are because our political leaders continue to show how lacking their knowledge is about basic economics.   

As Brown and Sarkozy see it, oil volatility can be licked if we merely empower the "Expert Group of the International Energy Forum" to "take the lead in establishing a common long-term view on what price range should be consistent with the fundamentals." A nice platitude for sure, but one totally divorced from reality in much the same way that seemingly all politicians think the wonders of prosperity are simply delivered upon us by some benevolent sole in the sky.

Back in the real world, the mildly sentient among us understand that even if the massive entity that is the oil market could be tamed by government decree, this would be a bad thing. Simplified, when governments seek to control the price of anything, shortages always reveal themselves.

In their defense, Sarkozy and Brown actually did happen upon a real problem within the oil sector, in particular the sad reality that for "two years the price of oil has been dangerously volatile".  In pointing to the symptom, however, they failed to explain the cause. In short, currency volatility very helpfully explains oil-price volatility, but nowhere in their piece did they mention the gyrations of the euro and pound, let alone the dollar. This significant omission reveals yet again that our leaders have no clue as to the cause of oil's gyrations.

The answer, however, lies in the failure of monetary authorities around the world to stabilize the value of the currencies they issue. Indeed, when we look at the euro, pound and dollar in gold terms over the last two years, we find that in British pounds the yellow metal hit a high of L693 versus a low of L422, in euros gold reached 784 versus a low of 482, and in dollars gold reached an all-time high of $1003 last year versus a two-year low of $652.

Importantly, gold hasn't been used as a money measure for thousands of years because it's unstable, but precisely because it's historically been seen as the best store of value due to its inherent stability. When gold fluctuates as it has in all three currencies, this isn't indicative of gold-price volatility, but instead is an example of the volatility of all three currencies in terms of gold.

Knowing as we now do that the euro, pound and dollar have been wildly unstable, it's then easier to see why oil has been so volatile. While oil is priced in dollars, its uniform nature means that we can price its movements in any currency. The oil price has been volatile both here and in Europe precisely because the currencies in which it's priced have had no defined value.

If the goal then is to reduce oil-price volatility, it's incumbent on Brown, Sarkozy and President Obama to reach agreement whereby the dollar would once again have a gold definition, after which monetary authorities around the world would peg their currencies to the dollar. This is what prevailed from 1944 to 1971, and as the attached chart reveals, when the dollar was stable in value oil was cheap, stable in price and never short in supply.  Contrary to Brown and Sarkozy's assertion that oil must be particulary expensive for investment to take place, the Bretton Woods years show that oil need only be steady in value in order for the intrepid among us to bring it out of the ground. 

Sarkozy and Brown note that the surge in oil "prices last year gravely damaged the global economy and contributed to the downturn." While that's certainly true, they misunderstand the cause.

Had our currencies been defined in terms of something real, the oil shock that was would never have been. Currency instability is what ails the world economy, and until we end the world's failed 38-year experiment with floating currencies, we can expect future periods of expensive oil for as far as the eye can see. In that sense the answer is simple: we must fix the dollar to gold in order to end oil-price volatility.