Why Are Oil Prices So High? Gold Solves the Riddle.

By Logan Flatt, CFA

   As the price of a barrel of crude oil continues to rise unrelentingly past $120 a barrel, one begins to wonder, Is the price of oil primarily rising due to the strong global demand for oil, or due to the U.S. Dollar (USD) falling so much in value?

   One way to solve this riddle is to travel back in time to the 20th Century when after World War II the USD was considered 'as good as gold'¹ because the exchange rate between the USD and gold was fixed by U.S. federal law at 1 USD = 1/35th of an ounce of gold; that is, until President Richard M. Nixon shocked the world by unexpectedly yanking the USD off the gold standard on August 15, 1971. Or, travel even further back to a time centuries ago when men and women the world over used gold as a medium of exchange, a store of value, and a unit of account. Back then, prices of almost all goods and services were quoted in units of gold. Looking at the price of oil from this historical perspective, a new question arises: Would the price of crude oil be rising so much if the world were paying for a barrel of oil with ounces of gold instead of the currently 'goldless' USD?

   Thankfully, we can use readily available historical data on gold, oil, and the U.S. Dollar to answer that question. The key is to transform the data -- and our thinking -- such that one ounce of gold becomes the currency (or, unit of exchange) that anyone could use to buy and sell a barrel of crude oil or to buy and sell the currently 'goldless' U.S. Dollar. Applying this data transformation and then using 1991 as a normalized index point (January 1, 1991 = 100) for both oil and the USD, the graph below uncovers a hidden truth: starting in late 2001 -- around the time of the September 11 terrorist attacks on the U.S. -- anyone could use one ounce of gold to buy an ever-increasing number of U.S. Dollars (the red line), or anyone could use one ounce of gold to buy an ever-decreasing number of barrels of crude oil (the blue line).

Image © 2008 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Used with permission. All rights reserved. Time period shown in diagram: 1/Jan/1991 - 6/May/2008.

   Looking at the graph another way, the red line reveals that an American today is having to spend over 2.4 times the number of U.S. Dollars he had to spend back in 1991 to buy a single ounce of gold (May 7, 2008 = 242). This is confirmed by comparing the USD prices of one ounce of gold in 1991 and today: $362 and $876, respectively.²

   Similarly, the blue line reveals that anyone today using an ounce of gold as a currency can buy only half as much crude oil per ounce of gold as he could in 1991 (May 7, 2008 = 50). In other words, anyone must now use twice as much gold as he could in 1991 to buy one barrel of oil. This is confirmed by comparing the gold ounce prices of one barrel of oil in 1991 and today: 0.06 ounces of gold per barrel and 0.12 ounces of gold per barrel, respectively.³

   So, a barrel of oil has doubled in price in terms of gold ounces since 1991 and, at the same time, an ounce of gold has more than doubled in price in terms of 'goldless' U.S. Dollars. Thus, gold solves the riddle: the price of crude oil is high and rising primarily due to the 'goldless' USD losing its purchasing power, and secondarily due to the strong global demand for oil. As the U.S. Dollar in his pocket becomes increasingly worthless, the average American is forced to cough up more 'goldless' U.S. Dollars to convince a seller of a barrel of oil to make a fair trade. Who can blame the oil seller if she believes "fair" requires ever more increasingly worthless U.S. Dollars to complete the sale of an increasingly demanded barrel of oil?

   Perhaps the riddle that the average American should be trying to solve has less to do with the price of oil going up and more to do with the purchasing power of the USD going down. Perhaps the real questions that Americans should be asking are:

• Why is the USD losing so much purchasing power?
  
  
• Why are our elected representatives in Washington, D.C. failing so badly in their constitutional mandate to provide We the People with a stable currency -- a currency 'as good as gold', or at least a currency actively managed by the Fed to within a tight range of gold prices?
  
  
• Why do We the People continue to elect representatives who think nothing of devaluing our currency through profligate printing and spending, rendering us all poorer and poorer as time goes by?
  
  
• When will We the People say 'enough is enough' and finally elect representatives who will honor their constitutional mandate to provide all Americans with a stable U.S. Dollar?

   Until We the People take action and demand real change in our federal government -- especially its monetary policy (stable dollar) and fiscal policy (balanced budget, lower debt) -- we will continue to watch  in dismay as the price of oil climbs higher and higher on the world market.

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¹In fact, the U.S. Dollar pegged to the gold ounce was considered even better than gold because lenders could charge interest on the gold-backed dollar but they could not charge interest on gold itself.

²Fundamentally, gold did not change at all from 1991 to 2008. Gold always has been and always will be the metallic element found within the Earth's crust that scientists have assigned the chemical symbol Au and atomic number 79. What has changed from 1991 to 2008 is the purchasing power of the USD -- and, as the graph indicates, that power has weakened significantly. Thus, anyone paying in U.S. Dollars must now use many more 'goldless' dollars to buy a single ounce of gold that is precisely the same today as it was 1991.

³Like gold, crude oil is simply earthen material. At base, crude oil is a hydrocarbon, an organic compound consisting of hydrogen (symbol H, atomic number 1) and carbon (symbol C, atomic number 6). However, oil springs forth from the Earth in a variety of different chemical flavors depending on the geology and geography of its source. Some people like it 'sweet', some people like it 'sour'; regardless, crude oil undoubtedly has become a hot commodity since 1991.

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