April 1, 2007
Many people still do not understand what happened to commodity prices in the 1970s, which is leading to various problems of interpretation today. The basic story is simple: the dollar's value fell, so it took more dollars to buy commodities. That's about all there is to it. Indeed, commodity prices fell -- a lot! -- in real terms, i.e. in terms of the amount of gold needed to buy them.
While the story is the same for virtually all the commodities, we will concentrate on petroleum, since that is one that grabbed the most attention at the time and which is getting the most attention now due to the possibility that it may have become very difficult to increase production any more than it is today.
Well, here it is, that Chart We Have All Been Waiting For, the King of the commodities price charts, the value of crude oil in gold oz.:
This chart is updated to March 2007, unlike our previous charts which only went to the end of 2003. Here we see some interesting phenomenon: there certainly seems to be a "central tendency" around the 80 oz. of gold level. That's about where we are now. There was also a period of depressed prices in the 1985-2000 period. Why?
The inflation of the 1970s caused confused price signals. Although the gold price of oil didn't do much, the dollar price of oil soared in the inflationary environment. This made oil companies wildly profitable, and to make more profit they produced more oil. At the same time, many interpreted the rising dollar oil prices to be a sign of shortage, and there was a lot of government pressure to produce more oil. Although the rate of growth of oil production in the 1970s was not as much as the 1960s, nevertheless this period is anomalously above the hypothetical Hubbert Curve for world oil production.
Do you see that peak in the late 1970s and the decline afterwards? It came almost completely via overproduction of the Middle East fields. Oddly enough, when prices collapsed in the late 1980s, there was actually less oil being produced than in the late 1970s. Interesting. And why were people using so much oil in the late 1970s, when there was supposedly an oil shortage? We can see by the top oil/gold graph that the real price of oil, measured in gold, was actually quite cheap in the 1978-1980 period.
While it is true that US oil production peaked in the early 1970s, this did not cause the rise in oil prices worldwide, and indeed the shortfall thereafter was easily accommodated by increased production elsewhere, resulting in cheap real oil prices for the next thirty years.
Just as the mistaken inflationary price signal confused the oil sector, it also confused commodity producers of all sorts, who overinvested, overproduced, and caused collapsing values for their products.
For investors, we see that today's oil prices are really, in 1960s dollars, about the same level as they were in 1960. However, the supply/demand situation is wildly different than the 1960s.
Thus, although oil prices in real (gold) terms reached their highest ever in late 2005, hinting at things to come, we really haven't seen any price reaction yet to the tightening supply/demand situation. Most of the oil rise since 1998 can be explained as a "return to normalcy" for prices plus a decline in dollar value (inflation). One thing we do know is that markets clear via the price mechanism, so it seems possible to me that we could return to the late-2005 levels or even 50% beyond that. At, say, 200 oz. of gold/1000 barrels (or a 5:1 oil/gold ratio), and the dollar at $1000/oz., both very feasible outcomes over the next 24 months, we get a $200/barrel oil price. Remember that the dollar is a floating -- or sinking -- currency, and it is entirely possible that we could see a barrel of oil worth $1 trillion from inflation alone. (In such a situation the real price of oil, in gold terms, would likely be depressed due to economic depression.)
In the early 1970s, several people became aware that humans' exponential growth would eventually hit the limits of the global Petri dish, and they tried to model when that may happen. For the most part, they concluded that around the first or second decade of the 21st century would be the time when people would reach the so-called "limits to growth." However, as commodity prices in dollar terms soared in the 1970s (even as their real values declined), people grasped on to this idea of "limits to growth" and concluded that humans were reaching those limits then, in the 1970s.
M. King Hubbert's estimate of world petroleum production, circa 1971. A core element of the "limits to growth" theories of that era.
This was completely wrong, of course, and when the Fed stopped boosting commodity prices via inflation, in the early 1980s, all those who thought that the world was Running Out Of Everything had a whole lot of egg on their face.
Newsweek magazine, November 19, 1973.
Humans have been "running out of everything" as soon as they started to mine minerals. It just hadn't got to the point where it mattered in the late 1970s.
As a result of the collapse of commodities prices (and the commodities industry) in the 1980s, the economics intelligentsia grasped onto the idea that there was plenty of everything, and in their view, there always would be. Some of these economists understood that the commodities price rises of the 1970s were wholly an inflationary (ie monetary) event, but most of them did not. The majority simply blew with the wind, and it was apparent that calling for commodities prices to soar to the moon was no longer the way to impress colleagues and nonspecialists. (Most professional economists hew to the most basic economic principles: get paid and get laid.)
Since people during the 1970s interpreted the price rises as evidence of shortage, they tended to blame the economic problems of that period upon commodity shortage. We can see from the chart of world oil production that there was no shortage during that time. Indeed, the rate of growth of production during the 1970s was far in excess of where it was in the 1980s and 1990s. There was a brief period of shortage in the US, the Arab Oil Embargo, which was complicated during the decade by various price-fixing schemes which also created artificial shortages. We can see the price-fixing schemes as flat plateaus on the WTI price chart, which persist until 1979. However, we can say with certainty that higher oil prices did not cause the inflation or recessions of the 1970s. They were a monetary event caused by the Federal Reserve, which led to higher nominal oil prices, even as real (gold) oil prices fell.
Now, even today there are a few Peak Oilers who see the problems of the 1970s as stemming from the peaking and rollover of US production in the early 1970s. This tends to lead to the conclusion that the peaking and rollover of production worldwide could have similarly disastrous consequences. I doubt it, but it must be said that monetary conditions (caused by the Fed and other central banks) bear a rather high resemblance to those of the early 1970s, so it may well happen that we will have a 1970s-style monetary disaster to accompany the rollover of world oil production, and all the Peak Oilers will claim that they were right!
Thus a bit of the history between the economist "cornucopians" and the "limits to growth" types. We will discuss this more in the future. However, we will end with one point about markets and how they react to the increasing difficulty of mineral extraction.
With a smoothly functioning market there should never be a shortage of anything. Markets match supply and demand, which is to say that "markets clear", and the definition of matching supply and demand is that there is not a shortage. What there is, instead, is price rationing. There is always price rationing -- if oil were $5 a barrel today we would probably be driving cars that get 5 mpg, just because we could. That might seem silly but people in the future, driving cars that go 150-200 mpg, will look back on us and consider our 25 mpg cars the same way we would consider a 5 mpg car. If oil were $200 a barrel today (a real price, not increased inflation), there wouldn't be a shortage. What there would be is a lot of people who can't afford to consume as much oil or gasoline when it costs $200/barrel for their oil, or the equivalent $8 per gallon of gasoline. However, if you fork over your $200 or $8 you would be able to buy oil or gasoline. It would be available. People don't use Gucci handbags for target practice, either, but the high price does not indicate a shortage of Gucci handbags. If you hand over your $4,000 the supply is practically unlimited. People would have to find a way to get by, whether by carpooling or turning off the air conditioning or moving closer to work or whatever. A certain sort of economist insists that "markets will find a way," and they tend to assume that that "way" is the creation of some new fuel source. However, it is becoming quite apparent that the easiest way for markets to clear in a situation of declining petroleum production is for people to use less. This is often called "conservation", which carries a certain moral tone, which is why nobody does it. In actuality it would be "minimizing expenditure," which everyone is quite adept at.
I see a great capacity to use less, ie "minimize expenditure", if or when the process of price rationing begins. Some may claim that you need 1000 gallons of heating oil to keep warm during the Maine winter. And it's true that IF you heat a certain drafty house in the same way as you always have, during the era of cheap fossil fuels, you may consume 1000 gallons of heating oil. However, if you instead choose one room in that house, and install 8" of Styrofoam insulation to the walls, ceiling and floor (or under the floor), and then plaster it all over so it looks nice, and you heat and use ONLY that room in winter (as people did in the days when the only heat source was the fireplace), then you might find that 100 gallons of oil is more than enough. This process, of going from 1000 gallons to 100 gallons, does not necessarily cause economic hardship.