Monday, June 22, 2009

Why Are Oil Prices Higher?

Despite evidence from Creighton’s three monthly surveys showing no immediate end to the recession ( ), many economists, pundits and analysts contend that the economic downturn is over. What evidence do they have?

It’s hidden in the price of oil, they say. In the past six months, oil prices (in dollars) have soared by more than 80 percent. The bulls contend that this is a signal that the economy is once again on the mend with U.S. economic growth driving prices higher. The bears, on the other hand, argue that this rapid expansion is the result of a weaker dollar and speculator oil buying. So which side has it right?

First, oil prices measured in Euros have risen by 27 percent. Thus, a large share of the increase in oil prices stemmed simply from a weakening U.S. dollar. Next using a simple economic model to explain oil prices since 1999, I conclude that almost none of the run-up in oil prices resulted from improvements in the economy. Instead, I find that of the 27 percent change in oil prices (in Euros), fully 10 percent can be explained by global investors desire to invest in oil rather than U.S. debt. That is, due to looming multi-trillion dollar federal deficits, investors have chosen to sell U.S. Treasury bonds of dubious value and buy oil. Of the remaining 17 percent increase, 4 percent, 7 percent and 6 percent are accounted for by seasonal factors, supply cutbacks and other unidentified factors, respectively.

In conclusion, the largest contributors to soaring oil prices over the past six months have been a weakening U.S. dollar and international investors selling bonds to buy oil.

Ernie Goss

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