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Who's to Blame for the Recent Spike in Oil Prices?

Everyone likes playing the blame game. High oil prices often get translated into high gasoline prices. So when oil recently hit an all time inflation-adjusted high at a price over $100 a barrel, we want to blame somebody. And that's understandable, so let's play the blame game!

Too Much Greed in the Oil Industry?

Who do we blame though? Hillary Clinton recently called oil company profits "the highest profits in the history of the world." That comment is so loaded with rhetoric, we can blow it up with our hands tied behind our backs and our eyes closed. She is of course referring to the dollar amount of the profit. That plays well to an ignorant public, but even Hillary Clinton is intelligent enough to know that if a company makes $39 billion in profit, which sounds like a lot of money, it may have taken $100 trillion to generate that profit. That's not exactly a company greedily making money hand over fist. We need to look at net profit margin for a more intellectually honest approach at measuring profit because it includes all the cost and investment required to generate the profit.

Net profit margin equals the net profit (what's left over after all costs are accounted for) divided by revenue, expressed as a percentage. This percentage represents the amount of each dollar of revenue that results in profit. Since net profit margin includes costs, we can compare say, oil companies, to say, banks and retailers. Let's look at the last 10 years of data to see if oil company profit margins warrant Hillary Clinton's vow to "take those profits."
 

I think it's safe to say that oil company profit margins are not obscenely high. But one last point on the profits in this industry. If Exxon reports profits of $39 billion in 2006, that means that to get a net profit margin of 9.7%, they actually invested $400 billion dollars to make that profit. In other words, Exxon put $400 billion into the economy by buying goods and services. The money Exxon invested put food on the tables of millions of people. You will not hear that story from Mrs. Clinton, even though she's smart enough to know it.

OK, so let's be done once and for all with the "evil oil company profits" story. The above chart shows the poverty in such attacks. We still need to blame someone for high prices at the pump, don't we? Yes, we do. Enter negative real interest rates.

Real Interest Rates

Imagine this scenario. You are told that if you buy gold, you can expect that it will increase at the rate of inflation. You call your local economist and find out that inflation is 8% annually and expected to stay relatively high for the next five years. Further, your local banker says that he can give you a five-year balloon loan at 4% to buy $1,000,000 worth of gold. You can buy gold, appreciating at 8% per year for a cost of 4% per year. Would you do it? Of course you would. So would everyone else. This would significantly increase the demand for gold, right?

The interest rate minus inflation is called a real interest rate. In economics, anything minus the impact of monetary elements such as inflation is called "real." Obviously then, when the interest rate minus inflation is negative, we have negative real interest rates and that's precisely the scenario painted with the gold example above. In times of negative real interest rates, all hard assets see an increase in demand because the appreciation will outpace the cost of financing its purchase.

Oil is, like gold, a hard asset. It too will appreciate as the financing cost dips below the expected appreciation. Could it be that oil has been on a tear lately because real interest rates have gone negative? The following chart provides the answer.
 

Notice that real interest rates not only turned negative again in November of 2007, but they've fallen to levels not seen since 1980. Could it be that real interest rates have contributed to the demand for goods and services that require oil because inflation has run amok concurrently with the Fed's easing policy? We think so. Opportunities like this don't happen often, but when they do, you'd better make hey while the sun's up.

One final chart shows the real interest rate plotted over the price of oil going back to 1983, which is the first year we have oil futures price data.
 

Real interest rates were extremely low, around 0%, for much of the first three years of the millennium, but did not turn decisively negative until August of 2002. Real rates stayed negative until a brief spike in early 2005 and then turned decisively positive in late 2005. In those three years, oil more than doubled from $26 per barrel to $57 per barrel. In the time real rates climbed above 0% in late 2005 to their peak in October 2006, the price of oil went up $1 per barrel. Since the peak in real rates, the price of oil has doubled again. It's up 20% since real rates turned negative in November.

The Culprit

So now we are in a position to place blame, and it should go to whoever is responsible for creating negative real interest rates. We need look no further than the Fed. Inflation (and oil prices are part of the inflation) will be the consequence of keeping rates low to stimulate our economy out of recession or avoid it before it becomes a reality. Unfortunately, the price for saving our economy from a near-term dip will be a much more pernicious disease - stagflation. We therefore think the days of cheap oil are long gone, and we now know who to blame.