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What’s oil got to do with the dollar and gold?

Thursday, 23 July 2009 - 3:05am IST | Place: Mumbai | Agency: dna

Late evening. A little drizzle. Me and her sitting on a bench overlooking the sea, under a single umbrella. “So?” she asked. “This is nice,” I replied.

Late evening. A little drizzle. Me and her sitting on a bench overlooking the sea, under a single umbrella.
“So?” she asked.
“This is nice,” I replied.
“Nice? That’s all? You use the word nice whenever you don’t know what you want to say!”
“Kind off.”
“I am bored,” she said coyly. “Since you claim you can link anything to anything. Let’s play a game. I will come up with three words and you link them.”
“Suits me.”
“So my three words are dollar, oil and gold.”
“You can’t think of anything but economics these days?”
“Chickened out already?”
“Not at all. But you should get ready to get back into history if you want to understand the link.”
“Yeah I am ready.”
“In the 1930s, Texas, the second largest American state, was producing so much oil that the price at times fell to as low as ten US cents a barrel (a barrel of oil is equal to around 159 litres). Now this was something that oil companies did not like. The Texas state government gave Texas Railroad Commission the power to regulate drilling of oil and thus set production levels.

Once the commission could regulate the production level, it could regulate supply of oil and hence indirectly regulate the price of oil, as well. This price became to be known as the Texas price and over a period, the Texas price became the US price and the US price became the world price. This arrangement worked very well for the US companies, which till the 1950s produced nearly half of the world oil. Hope this part is clear?” I asked.

“Yeah. Till now I have understood everything.”
“In 1928, Saudi Arabia gave an exploration license to Standard Oil Company of California for around 35,000 gold sovereigns. The company stuck oil in 1937. After this, more and more companies stuck oil in the Middle East. In 1960, the Organisation of Petroleum Exporting Countries (Opec) was formed. Opec comprised largely of oil producing countries from the Middle East. It was formed so that the countries could take on the big international oil companies, who till then had been dictating terms. Juan Palo Perez Alfonso, the Venezuelan oil minister, was the brain behind Opec. And the irony was that he had studied the way the Texas Railroad commission works when he had been exiled to the US. He used the Texas model to establish Opec.”

“You really seem to have history and economics all figured out,” she said.
“Well with your increasing interest in economics, I need to be ready all the time,” I said. “Now let me explain a few things about the dollar. Between the end of World War II and August 15, 1971, the US dollar was pegged to gold, with one troy ounce of gold (around 31.1 grams) being worth $35. Meaning, the US was ready to convert dollars to gold at any point of time. This ensured the dollar became the international reserve currency with other countries carrying out trade with each other in dollars because it was convertible into gold.  All this led to a lot of dollar pile-ups  across the world. Also, the US itself printed a lot of dollars to bankroll the Cold War and the Vietnam War.

This led to a situation where more and more countries started to exchange their dollars for gold. The amount of gold that the US government had was not infinite. So, on August 15, 1971 then-President Richard Nixon decided the US would no longer convert dollars into gold.”

“Aren’t you deviating from the point? Where is the link?” she interrupted. “Have some patience my dear. Till August 15, 1971, the US dollar was essentially gold. After that, it became a concept, an idea or just a piece of plain paper which had the backing of the world’s biggest superpower nation.

Also, during the first decade, Opec was not successful at doing what it was established to do. Between June 5 and 10, 1967, the Six-Day War broke out between Israel on one side and Egypt, Jordan and Syria on the other side. At that point, Opec had cut production by 1.5 million barrels, primarily to punish the US which was an ally of Israel. The production cut hardly mattered, because the US started to pump oil from its spare production capacity.

Oil production in the US peaked in 1970, and has been going downhill since then. At the same time, the American addiction to oil has been on its way up. In October 1973, Egypt and Syria went to war with Israel. This war came to be known as the Yom Kippur War. Opec, knowing well that America’s oil production had peaked, imposed an oil embargo. From October to December the Opec price of oil increased from $2.20 per barrel to $11.65 per barrel. Why do you think Opec had the audacity to do that?”

“Because, as far as I can see from what you said, oil production in the US had peaked in 1970. So the US did not have any spare capacity to pump up production and meet the shortfall from Opec’s cut in production. And given America’s addiction to oil, they had to pay the price Opec demanded.”

“That’s right to an extent. The global demand for oil had gone up from 3.7 million barrels per day (mbpd) in 1950, to 25.6 mbpd in 1970. So, an increase in demand was a definite reason for demanding a higher price. But what one must remember is that by taking dollar off from the gold standard, the US had the ability to print as many dollars as they wanted to, as they did not have to bother about having to face the risk of converting those dollars into gold.

And given their addiction to the so-called American way of life, they would print as many dollars as required to pay Opec’s price. Opec of course, understood this. If what you are earning is paper, then you’d rather have more of it than less of it. Once the US was ready to pay, the rest of the world followed.”
“Interesting. What happened after that?”

“Mohammad Reza Shah Pahlavi, the Shah of Iran, was overthrown by Ayatollah Khomeni on February 11, 1979. By May 14, 1979, the Opec price was at $13.34 per barrel. Oil till then was sold under long-term contracts. There was turmoil in Iran, causing its oil production to fall dramatically. This sent the spot price of oil through the roof, as Iran is the second-largest producer of oil within Opec after Saudi Arabia.”
“Spot price?”

“The day-to-day purchase market for oil was at Rotterdam in The Netherlands. Here, the price of oil shot up from $13.34 per barrel on May 15 to $34 per barrel on May 17. Iran cashed in on this and sold off their oil at the spot market. Soon, other Opec members followed. The spot price reached $40 per barrel and Opec raised its price to the same level. Opec again cashed in on the America’s addiction to oil and the fact that it could print as many dollars as it wanted to buy oil. With an increase in price, the inflow of dollars for the Opec nations shot up. Saudi Arabia and some other Opec countries started to use these dollars to buy gold and the price of gold also shot up through the roof, going from $258 per ounce in May 1979 to $678 per ounce in 1980.”
“But all that is history. What is the learning in the present day and context?”

“Well. I thought you would have got the point already. The price of oil fell to a low of around $30 a barrel, as economies all over the world crashed, reducing prospective demand for oil. But since then, the price of oil has been rising again and has risen to $60 a barrel. Opec of course understands that America can just print dollars to buy oil, as long as the international market for oil continues to be priced in dollars. Given that, why not have more dollars than less?

So, production of oil by Opec members has been adjusted accordingly to ensure a good price. Other than this, if Opec countries start buying gold with the dollars that they are earning — as they have in the past — imagine what would happen to the price of gold.”

“But how can you be so sure?” she asked. “Sure? In life, decisions are based on two kinds of guesses we make: wild guesses and educated guesses. I’d like to believe I’m making an educated guess!”
(The example is hypothetical)

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