Thursday, May 22, 2008

Oil price surge: market forces or inflation?

The other day I saw a chart that showed the value of the Dow in absolute terms, by dividing it by the price of gold to remove inflation. I thought that was pretty clever, so I made one of my own using historical prices of oil and gold going back to 1975 on a percent change basis. What I found was interesting.

Methods (boring, I know...): I indexed the price of oil, the price of an ounce of gold, and the price of a gallon of gasoline in yearly increments -- December of each year, to be exact. All percent values are referenced to the original values in 1975, or $160/oz gold, $12.21/bbl oil, and $0.53/gal gas.

The first interesting thing is that when you adjust for inflation, the price of oil has not changed that much since 1975 -- about 1.8 times. It steadily dropped until the 90's, and then began to rise again (presumably on the heels of a global rise in demand from China, India, etc.). Even so, it is my observation that the drastic numbers we see today are more of a result of inflation than the rise in global demand, or at least the rise that can outpace supply or production growth.

The second interesting thing is that irrespective of oil prices, gas prices have not kept up with inflation. The cost of a gallon of gas has been more stable than the price of a barrel of oil but they don't track on a 1:1 ratio. When oil hit its lows, it fell lower than the cost per gallon...but now that oil is at its highs, it has risen more than the cost per gallon. This is strange considering the fact that the amount of gasoline produced from one barrel of oil is the same no matter the price of crude.

Gas is 1.2 times more expensive in ounces of gold per gallon now than it was in 1975...compared to 1.8 times the change in a barrel of oil. Also, it's interesting to note that on an absolute value scale, gasoline is actually cheaper now than it was in 2000. The real kicker, though, is that over the past decade the absolute value of oil has increased about six times, while gasoline's absolute value has increased by a factor of 1.6. To put these numbers in perspective, if the price change of gasoline was to match the price change of oil, gasoline would cost $5.28 per gallon.

This leads me to believe two things. One, that oil companies are somewhat immune to changes of the price of oil on the commodities market since they buy and sell from themselves, essentially making the price of oil irrelevant for oil they produce. Vertical integration is their friend. Two, that oil companies actually do control the price of gasoline, not through collusion but through market economics. And this information leads me to believe that they have intentionally stabilized gas prices over the years! I think that ExxonMobil and others understand that if the economy tanks, they tank, and vice versa. So in the 90s, the price of gas did drop as much as the price of oil did, and now they're actually subsidizing the price of gas under the shadow of forcing the economy into a recession -- and reducing their profits short term profits. "Big Oil" is in the same economic boat as all of us, and they're maximizing their profits over the long term for that reason.

Finally, the effect of inflation on the global commodities market is staggering when looking at these graphs. It is yet another reason to curb government spending and end the Fed's (and the Bush Administration's) policy of a weak dollar.