US-made oil disaster has mileage

There is no end in sight to the recent strong gains in oil prices, endangering world economic growth and food equilibrium. This prediction is supported by our own modeling, which indicates that prices are more likely to go up than down in the near future. Could this mess have been avoided, why did it come about and what can be done?

The short answer is that the US Federal Reserve was in large part responsible for the oil price explosion and its volatility, while two successive US administrations have created the oil supply

shortfall, again adversely affecting oil prices.
First, let’s step back. Analysts are of course correct when they point out the obvious, that the oil and natural gas demand-supply balance is very tight and that this is the fundamental reason behind rising oil prices and its volatility.

For a number of years, energy demand has been growing rapidly, especially because of faster world economic growth, notably in China and India. The growing demand for oil and natural gas has been further reinforced because of environmental and safety concerns, in turn adversely affecting the demand for coal and nuclear energy. At the same time, supply and excess capacity of oil (the ability to produce more oil if needed) have not kept up. We will have more to say on the supply shortfall below.

But some analysts miss the wider picture on both the demand and supply side. The demand for oil and gas has been driven by a number of other factors. The Fed has injected an unprecedented level of liquidity into the market. Since 2001, by adopting an interest rate rule, the Fed has followed the most expansionary monetary policy in its history, setting interest rates at low levels and real interest rates at negative levels.

In response to the collapse of the credit and speculation boom, the Fed has set a deliberate re-inflationary objective in order to reverse falling asset prices. It has aggressively resumed its expansionary monetary policy since August 2007, cutting the federal funds rate from 5.25% to 2% with a consequent faster expansion of money supply, resulting in a rapidly depreciating dollar and disrupting stability in commodity markets, propelling oil prices from US$65 to $135 per barrel.

A depreciating dollar and rising oil prices have gone hand-in-hand. Oil prices are quoted in dollars; a falling dollar results in an increasing dollar price for oil. Given a falling dollar, oil producers and others with surplus dollars are reluctant to store their wealth in dollars but instead are diversifying into other currencies, largely the euro and the yen, again putting further pressure on the dollar and again driving up oil prices; or in some cases producers cut back output as they are reluctant to hold more dollars.

Asia Times