by Tom Whipple

Our peak oil crisis is morphing into a dollar crisis. Despite record
inventories, and millions of barrels sitting in anchored tankers, oil
prices continue to rise. Earlier this week the average price of gasoline
rose to $3 in California and many are predicting that the rest of us
will be seeing $3 gasoline later this year.

While analysts are moaning that $70 oil is not justified by supply and
demand, it seems that oil has become a favored store of value as massive
US deficits eat away at the value of the dollar. The dollar goes down;
oil goes up. For now there is so much excess capacity that geopolitical
developments, stockpile reports and run-of-the-mill oil news has only a
minor effect on oil prices.

Much of the recent run up in prices was based on this spring’s “green
shoots rally,” in which many professed to see signs that the recession
would soon be over, and that increased demand would send oil prices ever
higher. The rally, which had its origins in a change in accounting
standards allowing insolvent banks to pretend they were doing well for a
while longer, seems to be slowing and may be coming to a close.

While the psychology of the equity markets is in a world of its own,
most analysts, who don’t draw a paycheck from the financial services
industry, are saying that the tough times are only beginning. Some who
have studied the Great Depression are talking of a downturn lasting a
decade or more. Should this sentiment become widespread and the equity
markets start to move down again, it is an open question as to what
happens to oil prices. Can a falling dollar offset reduced prospects for
oil consumption from faltering economies?

The underlying cause for the dollar’s weakness is the massive deficit
the U.S. government is running, and the continuing sale of billions of
dollars worth of treasury securities. This in turn has left foreign
investors worried that the value of their U.S. treasury holdings will
one day be worth much less than they invested. For the foreseeable
future, these investors have nowhere else to turn, for the minute they
stop buying or try to sell significant quantities of U.S. obligations,
they would immediately crash the dollar and their worst fears would be
realized.

For now, China, Russia and other large holders of U.S. treasury
securities are trying to make the best of a bad situation. They are
talking among themselves about how they might transition to a new world
reserve currency and are slowly reducing purchases of additional U.S.
treasury securities.

For the immediate future, Washington has little choice other than to
issue unprecedented amounts of debt. Although the administration assures
us it will start cutting the deficit someday, this is tied to an
improved economic situation that seems problematic. Despite massive
intervention and purchase of treasury securities by the Federal Reserve,
U.S. interest rates are already moving up, with the rate on the average
30-year mortgage loan increasing from 4.86 to 5.59 percent in the last
few weeks, thereby choking off much refinancing and some new loans.
Another couple of jumps like this, and the U.S. real estate industry
will be having a lot more trouble.

If the U.S. dollar continues to fall, there is reason to believe that
increasing amounts of oil will be purchased as a hedge and that the
price of oil will continue to rise. The increase in oil prices does not
have to be as fast, nor go as high as it did last year to create serious
economic problems. The U.S. economy is in worse shape than it was 18
months ago, and is far more susceptible to the damage that would be
wrought by sustained exposure to $3 or $4 gasoline. Every 10-cent
increase in the price of gasoline takes $40 million dollars a day away
from other consumer purchases. The increase in gasoline prices over the
last six months is now draining an additional $400 million a day from
consumers’ pockets. For every cent gasoline prices increase, sales of
something else go down by $4 million dollars each day.

As strange as it may seem, the peak oil crisis, which has been focused
on geologic constraints to oil production, supply and demand,
geopolitical threats and inadequate investment, seems to be morphing
into an issue of how much debt the U.S. Treasury can sell and still keep
interest rates under control.

We can be certain that the U.S. Congress and government will not stand
by and watch oil price increases driven by a falling dollar wreck the
economy. As we saw last summer, there will be calls to break the
dollar’s link to oil by restricting or even banning speculation. How
well this will work in a globalized world is anybody’s guess. Unless
there is worldwide agreement, activities banned in the U.S. could
continue in Europe, the Middle East or Asia.

The more traditional constraints on world oil production – geologic,
geopolitical and inadequate investment – are likely to come into play
within the next three or four years, no matter the course of the current
recession. Right now there is a surplus of production capacity, and
indeed, already produced oil which is sitting around looking for
consumers. If for one reason or another the recession deepens over the
next year or so, then these surpluses are likely to grow.

It would be a great irony if oil prices were to continue increasing in
the midst of substantial surpluses and falling demand.

/Tom Whipple is a retired government analyst and has been following the
peak oil issue for several years./