Saturday, April 23, 2011

Oil Situation May Be Worse Than You Think

By Kevin McElroy

NEW YORK (TheStreet) -- Oil is the biggest single cost input into any business, good, commodity or product. We know it, but it bears repeating.

So, if you're looking for a reason for commodity prices to rise, you probably don't have to look any further than the single biggest input.

Right now, oil prices are scratching around the $110 a barrel range, a price unthinkably high even three and a half years ago. Laughably high. Ridiculous. Who could afford gasoline costing more than $4 a gallon?

The Financial Times recently published an astonishing story that just isn't getting enough attention. I like to think of the FT as the newspaper The Wall Street Journal would like to be if it weren't trying so hard to impress everyone with fancy Weekend sections and glossy magazine forays.

If you want to look distinguished, you might read the WSJ in public. But if you want to be informed, you'll also read the FT in private.

The story? The Saudis, as you may have heard, are increasing their social spending programs in an obvious attempt to deflate any "rebellious" ideas from their population.

They've recently announced a $125 billion spending program, which amounts to something close to 30% of GDP.

What it means is that the Saudi family will require a slightly ... higher sustained price of oil in order to break even. From the FT story:

"The break-even oil price the Gulf kingdom requires to balance its budget will jump from $68 last year to $88 this and then $110 in 2015, according to new estimates by the Institute of International Finance, a leading industry group."
Of course, even with the days of peak oil production likely in the rearview mirror, oil doesn't just double in price in a few years ... unless of course the currency you're using to price oil is also being devalued at a record pace.

So, you've got to start thinking that maybe Federal Reserve Chairman Ben Bernanke is starting to realize some of the disastrous effects of his devaluation policy

Oil contracts are settled in dollars, and the Saudis, as well as every other oil producer, don't have too much interest in playing along with the Fed's schemes.

The markets will continue to push oil's price higher and higher, as a simple function of dollar weakness. And the Saudis will continue to readjust their "break-even" number to account for dollar weakness. If they're not getting the price they want, they'll simply pinch the hose.

And as oil gets more expensive, that will make everything more expensive. Oops, that sounds like inflation to me.

With an $88 ledge under oil for one of the world's biggest oil producers, it seems like we can probably expect to continue to pay more and more for gasoline, of course -- but we'll also pay more for everything with an oil input.

Even commodities without an obvious tie to oil, like silver, are hugely energy intensive. Silver ore doesn't climb out of the mines itself. We can expect silver prices and oil prices to move more or less in tandem, especially since they're both extremely sensitive to movements in the dollar.

I hope it's a chilling reminder for Bernanke that even though he's the master of the Federal Reserve, he has very little actual control over the markets, and that every action he takes to thwart the market will have unintended consequences that are probably worse than the problem he was trying to fix in the first place.

Higher-priced oil, and therefore, higher-priced everything, is just the biggest example.

The Street


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