Home Business & Finance Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them
As happens in the case of gold, the price of oil is primarily set in the futures markets. Oil is often referred to as black gold and it is even more enmeshed in politics than the yellow metal. This is mostly owing to the fact that the supply of oil happens to be concentrated in countries subject to political instability. Moreover, their relations with Western countries are often chilly, if not outright hostile. Of the ten nations possessing the greatest amount of proven crude oil reserves as of 2015, only one, Canada, is a stable Western democracy. Among the others in the top ten are Saudi Arabia, Venezuela, Russia, Libya, Iraq, Iran, and Nigeria. Certainly, significant price increases have ensued upon revolutions and wars in these countries. Think of the 1973 Yom Kippur War and the 1979 overthrow of the Shah in Iran and its replacement by an Islamic theocracy. Also worthy of mention here is the eruption of the Iran-Iraq War in 1980, Iraq’s 1990 invasion of Kuwait, along with the 2003 invasion of Iraq led by the USA. After that, there was the so-called Arab Spring, the movement toward democracy that began with the 2011 overthrow of Zine El Abadine Ben Ali in Tunisia. Later spreading to Libya, where Western powers intervened to effectively back rebel forces against the Muammar Gaddafi regime, this phase of the Arab Spring caused a spike in oil prices. The ideal of democracy proved then to be a disruptive element in the oil arena, as ruling elites forcefully resisted challenges to the status quo unleashed by the Arab Spring. Nowhere was this more evident than in Syria, where the Bashar al-Assad government brutally repressed opposition forces. By 2015, amid all the devastation created by four years of civil war, waves of Syrians had left the country, sailing in rickety vessels and walking thousands of miles to seek refuge in Europe.
Indeed, a strong case can be made that the abundance of oil in the Middle East is precisely what makes it harder for democracies to consolidate themselves there. Impeding any transition to democracy is the resource curse. Countries plagued by this curse sit on valuable and plentiful natural assets. Yet precisely because of this, they are more likely to experience lower economic growth than nations not so well-endowed. Nature’s bounty acts as a magnet that pulls political elites into a ferocious competition to seize control of the country’s resources. Whoever wins this battle can use the wealth acquired to capture the state apparatus and maintain control over it by rewarding supporters. The ruling group that emerges from this struggle can then proceed to reduce political competition by using the state’s coercive power to neutralize threats to their authority. Though the country may still exhibit the appearances of lavish wealth, particularly in its capital city, the result is that the economy winds up performing less than optimally. For investment decisions are made with a view to the political interests of the governing class, rather than on the basis of profit expectations. In addition, too much effort is put into resource extraction at the expense of other industries, as politicians direct the gains toward their personal coffers, pet projects, military forces, and constituencies. By equipping their soldiers with good pay and sophisticated weaponry, the regime is able to win the loyalty of those who enforce the state’s authority, furnishing them the means of beating down political opponents. No doubt Syria’s oil wealth, though not especially sizable by world standards, has helped the Bashar al-Assad government do just that in that country’s civil war. Consider as well that by using the revenues generated by oil to offer a generous array of government jobs, social benefits and subsidies within a framework of low taxes, ruling elites ensure the quiescence of the populace. This is a tactic that was successfully used by Saudi Arabia’s monarchy in raising public sector pay and housing subsidies as protests against autocracy spread throughout the Middle East in 2011.
The resource curse can be avoided. The condition is that the institutional setting maintains property rights and contracts. Necessary, too, is an institutional system of checks and balances that aligns the incentives of politicians closer toward policies favoring economic efficiency and growth maximization. This explains why countries like Canada and Norway have demonstrated a greater immunity from the resource curse than elsewhere. Even so, as the experience of these nations attest, good institutions have to be already in place for the resource curse to be contained. As a general matter, the negative correlation between oil and democracy is strong. According to one quantitative study, a 100 billion barrel discovery of oil tends to reduce a country’s level of democracy, as measured by the Polity index, by 20 percentage points below trend over a three-decade period. In line with the exceptions to this pattern in Canada and Norway, the negative effect of oil is more pronounced to the extent that democracy was not present when the oil find was made. Alternatively, one can use the Freedom House Rights index as a measure of democracy. Variations in this measure further confirms the inhibiting effects of oil, according to an analysis of up to 156 countries from 1972 to 2002. In the Middle East, oil both impedes democracy and is destabilized by the prospect of it—though it we must recognize that the oil futures markets in and of themselves are not responsible for any of this. The fact that oil is priced where it is by the markets does make it a resource valuable enough to work as a curse among nations amply endowed with it. But in setting the price, traders of the West Texas Intermediate and Brent crude contracts are only reflecting the demand and supply conditions of oil.
Obviously, OPEC (Organization of Petroleum Exporting Countries) cannot go unmentioned in a political accounting of the oil market. While the 12 nation cartel holds 80 % of the world’s proven oil reserves, its ability to control the price of oil has diminished since the 1970s, when its actions generated the largest daily percentage price change in the history of the commodity. On January 1, 1974, OPEC single-handedly took the price of oil from $4.31 to $10.11 per barrel, a 135 % increase. In 1979, it raised the price twice by 15 % on the way to oil hitting a high of $39.50 per barrel a year later. Afterwards, though, the cartel’s power waned, only reviving somewhat in the late 1990s, when it helped resuscitate the oil market from the doldrums of traversing the $10 per barrel zone. News that OPEC is about to meet and possibly negotiate new production limits can still move the oil market, but the intergovernmental organization has largely succumbed to the fatal vulnerability of cartels: each member has an incentive to free ride on the production limits the others are following by supplying more than its assigned quota to the marketplace in order to take advantage of the artificially high price. Once a sufficient number of members attempt to cheat like this, the supply of the good increases enough to drive prices back down toward market levels, thereby nullifying the cartel’s efforts.
Consequently, whenever oil prices now rise to the point of eliciting the ire of the consuming public and the politicians coveting their votes, attention is no longer drawn so much to OPEC, or even the big oil companies, but rather to the energy futures markets. Why the black liquid sparks such anger is the result of its correlation with the price that individuals pay to fuel their vehicles at the pump, unleaded gasoline being refined out of crude oil. Other forms of energy such as heating oil, diesel, kerosene, and jet fuel are also made from crude oil. As a result, the oil price ends up representing a major cost that firms must ultimately cover to produce goods and services. With any upward movement in crude oil prices thus squeezing both consumer wallets and corporate profits, it is no surprise that a 10 % increase has been estimated to have a statistically significant impact of anywhere from -0.3 % to -0.6 % on US GDP over a 12-month period. World Bank simulations suggest that a $50 rise is associated with a decline of greater than 1 % in annual GDP. Ever since energy markets became more volatile in the mid-1970s, every recession has been preceded by a significant increase in the price of crude oil.
It should be noted that this effect only holds for importing countries. Those countries which export generally gain from price increases, particularly developing nations heavily reliant on the oil industry. But as the leading oil futures markets are located in Western developed countries where the weight of export sector is either zero or relatively smaller—the Brent Crude contract trades on the Intercontinental Exchange (ICE) in London whereas the West Texas Intermediate Light Sweet futures are transacted on the NYMEX—political and regulatory pressure there will reflect the power of consumer interests. Accordingly, in 2008, a dramatic ascent in NYMEX crude oil futures that saw these go from $87 to $146 per barrel in a matter of six months was met by US Congressional hearings into charges that speculators were causing a bubble.
Again, in early 2012, after a run up in NYMEX oil from $75 to $110, members of US Congress demanded that the regulatory body overseeing the US futures markets, the Commodity Futures Trading Commission (CFTC), reduce the number of contracts that traders are each allowed to assume, a proposal that was later nixed in the courts, a ruling then followed by another proposal. The underlying premise in the call for position limits is that large players drive oil prices well above what the economic fundamentals would imply by flooding the market with a huge influx of buy orders.
Since the 2008 rally, a number of academic and public policy studies have explored the claim that speculative forces caused the price spike. Testing historical price movements against models that specify the correct range for oil given the factors known to impinge on its value, a few analyses suggest that speculation played a role in lifting prices. Corroborating media accounts at the time, a well-publicized report favorably cited by various members of US Congress lent support to the bubble thesis. It pointed to the correlation between money flows into commodity index funds and the upswing in oil prices. The report also noted that supply and demand figures were relatively unchanged during the 2008 acceleration of the rally.  In sharp contrast, the CFTC issued its own report on the oil market, detailing how growing demand consistently had outpaced supply since the early 2000s. This is a finding buttressed by scholars associated with the Centre for Economic Policy Research. They explain the entire upward trend from mid-2003 to mid-2008 as a function of global economic growth projections continually being surpassed by better than expected performance in Asia’s emerging markets. з 5 Moreover, the bubble theory only makes sense if a private inventory of oil was accumulated and deliberately kept off the market. Otherwise, the high prices being transacted on the futures market would have attracted new supply and hindered the rally. But no such inventory has ever been conclusively identified. Other scholars have noted the lack of a consistent relationship between commodity index trading activity and commodity price movements. While oil was on the rise, a wide assortment of agricultural goods simultaneously experienced sizable price increases. With respect to some of these goods, index traders had taken no positions or were unable to do so owing to the lack of a futures market for those commodities. Making index investors the culprit can only be justified if their trading activity were present across all the commodities that spiked upward in price—logically speaking, X can be assigned as the cause of Y, only if X is found to be operating in all instances of Y.
Around the time oil was nearing its peak, James D. Hamilton, a leading scholar of the black liquid’s price dynamics, modestly observed that a definite judgment about the speculative nature of the rally would have to wait until the passage of time disclosed whether the price rise stuck. By this standard, the bull market in oil may have gone a bit too far, inasmuch as prices collapsed in the second half of 2008, eventually hitting a low of $30 per barrel in December of that year, a staggering 79 % drop from the $146 high point established about six months before. Still, as the demand for oil rises and falls in tune with the pace of general economic activity, this precipitous decline can be explained by the ominous deepening of the financial crisis during this period and the resulting expectations among market participants of a deep recession ahead. After the economy subsequently revived, oil prices eventually found their way back above $100 per barrel by 2011 and 2012 before ending the latter year in the $80 range. A couple of years later, oil did collapse spectacularly in price, eventually settling in the $35-40 zone by the end of 2015. But that was hardly telling of anything about the prior run-up in prices. That drop had taken place, after all, at a minimum seven years proceeding the run-up from 2003 to 2008. Oil fell toward $35-40 because of an increase in US oil production.
This, in turn, was mostly due to the application of new fracking techniques that make it possible for oil to be drilled from otherwise inaccessible rock formations. Also contributing to oil’s decline was the decision by Saudi Arabia, the leading member of OPEC, not to cut production in an attempt to shore up prices. Further adding to the pressure on oil prices was the growing obviousness of a slowdown in China’s economy. Tellingly, amid this steamroller of a bear market, charges that speculative excesses in the futures markets had taken the price of oil beyond its true value were notably absent. This is despite the fact that the crumbling of oil during 2014-2015 was analogous in speed and magnitude to the accelerated shoot upward in price that provoked so much outcry in 2007-2008. The only difference was that in 2014-2015, the price traveled in a direction that favored the interests of voters in the USA and much of the developed world. Noting this discrepancy, a fair-minded observer is taught to look skeptically on politically charged assertions of market mispricing.
None of this, however, is to deny the remarkable volatility of oil prices over the past several decades. So remarkable have those gyrations been that to explain them one is compelled for an explanation that goes beyond real factors, namely authentic variations in the supply and demand for oil, and consider monetary factors instead—that is, the money made available by the financial system to buy and sell oil. Among orthodox economists, the connection between oil prices and the money supply is generally seen to only possibly go in one direction: from a rising oil price to a tightening of monetary policy, as the central bank endeavors to stanch the inflationary implications of higher energy costs. But consider the graph below (Fig. 6.8) depicting oil prices both before and after the early 1970s.
As James D. Hamilton once observed: “One’s first thought might be that someone has pasted together two or more radically different series”. Throughout the 1950s and 1960s, indeed up until 1973, the crude oil price appears on the graph as an essentially flat line, trading as it did between $2-3 per barrel. Afterwards, the price suddenly takes off and zigzags a lot more. The usual explanation for this is that, starting with the 1973 Yom Kippur War, OPEC began to use its control of oil prices as a political weapon against Western support of Israel. This is usually combined with a story about the inelasticity of oil supply exacerbating the short- to medium-term price effects of shifts in demand. According to this
Fig. 6.8 Crude oil prices, 1950-2015. Source: St. Louis Fed
story, these effects have become all the more magnified with the rising economic fortunes of the developing world. The flaw, however, in this conventional narrative is that it neglects how the value of the instrument in which oil is priced worldwide, namely the US dollar, came unhinged in the early 1970s. True, one can attempt to obviate this problem by looking at the real, or inflation-adjusted, price of oil. This figure is calculated by discounting the nominal price of oil by the CPI. Like all price indices, though, the CPI is a less than perfect gauge. Nobody “average” actually exists that purchases the basket of goods used to calculate the monthly inflation measure. Nor can a numeric series take changes in product quality into account. A more illuminating means of interpreting the oil market is available. As already mentioned, it has a record of tracking changes in the tenor of monetary policy. It also has a long history as a medium of exchange. I am speaking, of course, of gold.
As Fig. 6.9 shows, oil looks very different when priced in terms of gold. From 1950 to 1971, oil trades within a tight range of 10.5-13 barrels per
Fig. 6.9 Barrels of crude oil per troy ounce of gold, 1950-2015. Source: St. Louis Fed
ounce of gold. After closing at 12 barrels per ounce in August 1971, oil then breaches its previous range, quickly reaching the 33 barrels per ounce level in mid-1973.
This meant that oil-producing countries now had to give up almost three times as much of their precious black liquid in return for an ounce of gold. Oil’s decline in value here is more numerically evident if we consider its gold price. That oscillated between the 0.07 and 0.09 ounces per barrel range from 1950 to 1971, before declining to a low 0.029 in mid-1973. Even before the Yom Kippur War gave it a convenient excuse to raise the oil price, OPEC had already been complaining about the losses induced by the dollar’s devaluation and continued to do so throughout the 1970s. Indeed, US President Jimmy Carter’s 1979 decision to replace William G. Miller with the more hawkish Paul Volcker as chairman of the Fed occurred, perhaps not so uncoincidentally, after OPEC threatened to unload the American dollars it had accumulated selling oil and to proceed pricing oil in another currency.4 1 As such, the broadly prevailing force guiding OPEC pricing decisions was not Middle East politics. It was the desire to preserve the exchange value of its oil assets from being eroded by the easy money policies of an America no longer constrained by Bretton Woods.  By end of the 1970s, OPEC had succeeded in this task, having brought oil closer to the pre-1971 range vis-a-vis gold. Afterwards, the oil per ounce of gold price continues to swing dramatically.
Interestingly enough, a linear regression line drawn to most closely fit all the monthly price points from 1950 onwards reveals a very slight upward trajectory in the number of barrels necessary to obtain an ounce of gold. This longer-term trend gauge shows oil going from about 13 barrels to 15 or, equivalently, 0.077 to 0.066 ounces per barrel. That oil has tended to decline when measured against a stable unit of value whose quantity cannot be augmented at will is precisely what one would expect during a period of economic growth. Through increased productivity and the more efficient use of inputs, economic growth increases the quantity of goods available, thus lowering their price, everything else remaining equal. That oil has only trended slightly downward testifies to the political risk premium that has been built into the black liquid. It also testifies to the evolution of a more delicate supply-demand dynamic. Not surprisingly, other less politically contentious, and more renewable, commodities like corn, soybeans, wheat, and cotton show larger declines when priced in gold over the same time frame. Even if against the backdrop of a stable long-term trend, it must still be acknowledged that the crude oil market has been marked by greater near-term volatility. But a good part of the reason for these undulations includes the uncertainty created by the state’s assumption of complete discretion over the money supply.
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