Yarpb’s Weblog

Reality Made Simple

Oil Prices for Dummies

In last night’s ABC debate, the concept of high oil prices came up.  Only one person, Ron Paul, gave a coherent response to the question.  Pretending that the only factor driving the price of oil is supply and demand is simply ignorant.

Facts: The concept of currency value can be somewhat complicated.  The oil market can be somewhat complicated.  The gold market can be somewhat complicated.

 All of these things are related to one other in a web of complication.  You don’t need to be an economist to figure this out.  It is actually quite simple if you take the pieces apart.  But to start, here are some facts:

  1. All oil is traded in US dollars — even on the London oil bourse.
  2. The dollar fluctuates in value against foreign currency.
  3. The dollar has no finite backing, other than oil (a.k.a. the petrodollar)

Let us assume, for this example that one eurodollar is equal to one dollar.  That means if I go to Europe and buy a gallon of gas (yes, I’m aware they’re sold in liters in Europe) for 3 euros, I have bought a gallon of gas for 3 dollars.  Now, let us look at the real value of the euro vs. the value of the dollar.

As of today, 1 euro is equal to about 1.5 dollars.  So if I buy a gallon of gas for 3 euros, I’ve bought a gallon of gas for 4.5 dollars, because 3 times 1.5 is 4.5.  This is an example of exchange rates.

Now, as the dollar falls in value, the oil exporting countries raise the price of oil to compensate for the falling dollar.  Remember, all oil is traded in US dollars.  So if 1 euro is equal to 1 dollar, and a barrel of oil costs 30 dollars, a barrel of oil is 30 euros.  But if the euro is equal to 1.5 dollars, the oil countries have to charge 45 dollars to make that same amount of money in euros.  The actual pricing of oil is much, much, more complex, but for the sake of simplicity, this explanation is fair.

Add to all of this that the dollar is not backed by anything (except oil, which is really nothing).  So if you create new money (a.k.a. no gold standard), you’re devaluing the dollar vs. oil.

Let us assume that the dollar is backed by a jug of milk and that there is a total of 100 US dollars in circulation.  If we all of the sudden decide that there are now 200 dollars in circulation, while we only have one jug of milk, the price of that jug of milk immediately doubles to 200 dollars.  This is how the gold standard works.  This is a 10 year graph of gold prices:

The US is, in fact, on a gold standard of sorts.  The problem is that we keep increasing the amount of US dollars, which increases the price of gold.  Instead of backing the dollar in gold, we changed to backing it with oil.  And the amount of oil produced does not correlate to the amount of gold available.  As such, the value of the dollar fluctuates in regards to the value of gold — but the value of gold has never really changed.

If you don’t believe that the US dollar is backed by oil, you can look at the value of the dollar vs. the value of the currency of oil exporting countries:

When Ron Paul discusses topics like this, the other candidates attack.  The fact of the matter is they don’t understand the complexity of the global market, so they react the only way they know how, which is ad hominem attacks.  Here is Dr. Paul’s rational explanation:

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January 6, 2008 Posted by | Economy | Leave a comment