Tuesday, December 23, 2008

Oil, the Dollar, International Trade

The price of oil is tricky, because it is priced on more than just its value as oil. In today's world economy, oil has become like cigarettes in prison, or gold in the middle ages, a widely traded commodity that substitutes as a store of value. In the old days, when the dollar fell, investors would flock to gold, but today that no longer holds, because there is simply not enough demand for gold. Today, when the dollar falls, people flock to oil as a store of value.

Thus, if the dollar is falling, you can put your $100 in oil, then two months later, that same amount of oil is worth $110. If you kept your money in dollars, two months later your $100 may only be worth $90. When the dollar is falling, the rule is: keep your money in dollars and you lose your value, but keep your money in oil and you gain in value.

The dollar is falling this week because of the zero interest rate policy of the Fed. Investors can make more money in Europe, where banks have higher rates, so they are fleeing the dollar for the euro. This is a huge problem for Japan and China, because their economy depends on exports to the U.S., and they hold massive amounts of dollars because of their trade surpluses with the U.S. (they are the number 1 and number 2 holders of U.S. government debt as a result). A fallen dollar means not only that their dollar holdings are dropping in value, but that their economies could be wrecked because of a fall in exports, as all their exports to America are shooting up in cost for Americans. Japan's yen has been falling lately against the dollar, and they are going nuts, threatening central bank intervention. That would mean they would use all those dollars they have to purchase yen, defeating the downward market pressure on the yen. If they have more dollars than downward pressure, they win and the yen stays high. If downward pressure on the dollar exceeds their ability to fight it, the yen shoots up, further wrecking their economy and the value of their dollar holdings. Essentially, it is vital for them to keep their currency tied to the dollar at a rate that advantages their exports.

What if international trade switched to something other than the dollar, such as the euro? The demand for dollars would instantaneously drop, leading to an oversupply of dollars, leading to a drop in the value of the dollar, leading to massive inflation in the U.S. Presumably, the Fed would have to soak up the extra dollar supply with high interest rates, what was done in 1981, ending the stagflation, and causing a severe recession. Ah, you see the problem? We are already in a severe recession, and the Fed has dropped interest rates to absolute zero in an attempt to stimulate the economy. So what could the Fed do to end an inflation in a situation of economic recession? If you guessed "nothing" you get the prize. This is, in fact, the reckless course the Fed is currently charting, intentionally creating a massive oversupply of dollars during a severe recession. They think they have learned the lesson of the Great Depression, that the Fed was too tight on monetary supply, leading to a sustained deflation and a lost decade of economic growth.

As you can see, the entire world economy is hinged on the fulcrum of the U.S. economy, expressed in U.S. consumption levels, the dollar value, and the trade in oil. Europe's economy is far less dependent on the U.S. than Asia, so their currency looks to be the strongest, and they will be the ones most likely to break the oil trade in dollars. As we have seen, breaking the dollar trade monopoly would radically devalue the dollar, hammering the U.S., Japan, and China, while advantaging Europe and the Mid East. Japan and China would like to hold monetary assets that hold their value, so they would obviously drop the falling dollar if they could, but they appear to be locked in, having so much in dollar reserves, and depending on exports to America.

Japan, who's economy is already in an recession, now faces a big devaluation in its currency,, because US interest rates are now lower than Japan's.

China will also do anything to keep its economy chugging along, which means suppressing the wages of its workers, suppressing the value of its currency, and subsidizing the prices of energy, as demonstrated today, as China "cut prices for gas, diesel, and jet fuel". Only in a fascist economy like China can they simply declare the price of their fuels. Of course, that does not indicate they can control the real cost. In reality, they are just passing along the savings of cheaper oil, which the rest of the world except the Chinese consumer has enjoyed for awhile now.

Isn't it amazing how all these systems get balanced on one another?

Oil, down to $37 in January, is slightly up above $40 for February, but falling demand renders OPEC cuts impotent. The dollar is also falling, which normally sends oil up, but falling demand for oil is even more powerful right now, keeping oil down. That's how bad the economy is getting, with industrial activity grinding down and layoffs skyrocketing.

Crude prices fall again as markets ignore historic production cuts from OPEC. Oil continued its downward march Thursday as mass layoffs pushed the U.S. economy deeper into recession, signaling a drastic pullback on energy spending. Light, sweet crude for February delivery, fell $2.10 to $42.51 barrel on the New York Mercantile Exchange. The January contract, which closes on Friday, fell 6 percent, or $2.41, to $1.42 to $37.65 after dropping as low as $37.68, levels last seen in the summer of 2004. "The market is saying OPEC cuts will have an impact but just not right away," he said. Analyst and trader Stephen Schork said. Actions by OPEC and tumbling fuel prices have failed to stimulate demand. "OPEC is virtually powerless right now," said Jim Ritterbusch, president of Ritterbusch and Association. "They'll simply have to be patient and wait for some semblance of demand improvement." Beutel said it could be several more months before there is a response to lower prices.

Schork said crude prices have further to fall. Economic data continues to paint a dire situation in the U.S., Europe and Asia. The U.S. Labor Department reported Thursday that new applications for jobless benefits fell to a seasonally adjusted 554,000 for the week ended Dec. 13, from an upwardly revised figure of 575,000 the previous week. Still, the four-week moving average, which smooths out fluctuations, increased slightly to 543,750 claims, the highest since December 1982. The labor force has grown by about half since then. Large layoffs are occurring across many sectors of the economy. On Wednesday alone, hard drive maker Western Digital Corp., managed-care company Aetna Inc., and Newell Rubbermaid Inc., maker of products including Rubbermaid storage containers and Sharpie pens, announced mass job cuts. Pharmaceutical company Bristol-Myers Squibb Co., International Paper Co. and Bank of America Corp. also announced layoffs in the past week.

On Thursday, the Conference Board, a private research group, said its index of leading economic indicators fell 0.4 percent in November. The index is meant to forecast economic activity in the next three to six months. It has dropped 2.8 percent in the six months through November, the worst decline since 1991. As companies and consumers spend less, analysts continue to whittle away energy demand expectations.

This week's dive in oil prices comes as the dollar weakens against the euro, which peaked at $1.4719 in overnight trading, its highest point since late September. Typically, a weaker dollar sends investors scurrying into the oil markets because crude is bought and sold in U.S. currency. That is what happened as prices made their historic run at $150 over the summer. The severe drop-off in demand, however has scuttled almost all of the rules that traditionally goveren trade in oil, as the OPEC production cuts show.

China on Thursday cut prices for gasoline, diesel and jet fuel as the government tries to revive economic growth. The price of diesel is being cut 18 percent while the price of gasoline will fall by 13.8 percent, effective Friday, according to the country's planning agency, the Cabinet's National Development and Reform Commission. Jet fuel prices will fall by 32 percent. The cuts will help trucking companies, airlines, factories and others that are being squeezed by high fuel prices and a slump in sales.

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