Oil Isn't 'Expensive', the Dollar Is Cheap

In his classic book, The Theory of Money and Credit, Austrian School economist Ludwig Von Mises plainly observed that "Whenever money is valued by anybody it is because he supposes it to have a certain purchasing power." Von Mises's views on money loom large considering the nosebleed price of oil that American consumers continue to suffer.

Though it's well down from highs of $147/barrel that it reached in the summer of 2008, that the price of a barrel of oil still trades in the $79 range is a certain signal that something is amiss.

Perhaps unaware of the dollar's undefined, floating nature, commentators continue to point to the oil price to support their suggestions of foul play on the part OPEC, too much global demand for what is allegedly a limited commodity, or greedy "speculators" keeping the price of the world's fuel at abnormally high prices. Influential newsman Bill O'Reilly frequently fingers speculators when attempting to explain the price of oil to his viewers.

In each instance commentators mistake the symptom of expensive oil for its true cause. Von Mises frequently touched on money values in his brilliant expositions on markets, and it's because the dollar has no true value or fixed definition that oil is presently expensive. In short, oil is dear because the dollar in which it's priced is cheap.

For background, it's worth mentioning that 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 correlation between the two commodities, many economics writers took to explaining 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.

Considering oil's aforementioned spike to $147/barrel in 2008, an ounce of gold then only bought 6.8 barrels of oil. What this meant at the time was that oil was due for a major correction as its price fell back to historical ratios. In that sense, oil's collapse from nearly two years ago was less a function of reduced global demand and allegedly "benevolent" speculators, and largely a function of it returning to its normal relationship with the gold price.

Right now gold trades in the $1176 range, and the price of oil is roughly $79 per barrel. That an ounce of gold buys 15 barrels of oil signals yet again that the real price of oil has hardly changed at all over the last 10 years of allegedly costly crude. Still, $79 oil ensures $3/gallon gasoline as far as the eye can see, and it's a fair bet that the price will stay there so long as gold continues to test all-time highs.

The good news, however, is that this can be fixed. As evidenced by the dollar's major decline versus gold this decade, the dollar is very cheap. The dollar's debased nature explains expensive spot oil prices, high prices at the pump, and most important of all, it helps explain a difficult job outlook. With so much soggy money flowing into commodities least vulnerable to dollar weakness, the entrepreneurial economy where most jobs are created is losing out.

So the answer is really quite simple. If we want cheaper gasoline, we need the U.S. Treasury to target a stronger dollar, and for it to even threaten intervention if markets unexpectedly fail to comply. If a $500 gold price is targeted as so many gold-watchers would prefer, the stronger dollar will sooner rather than later reveal itself in greatly reduced oil prices; roughly $33/barrel if historical gold/oil ratios once again prevail.

For now though, it's a waste of time to bemoan what many deem "expensive oil." Time is wasted because there's no such thing as expensive oil, and there never has been. Instead, we have a problem of Americans supposing that the dollar is fixed in value, when in fact the dollar floats.

Oil hasn't become expensive this decade; rather the dollar has become very cheap. Strengthen the dollar, and worries over nosebleed gasoline prices will quickly become a thing of the past. Absent that, to hope that something will become inexpensive when the unit of account in which it's priced continues to fall is to indulge in fantasy.