I originally wrote this as one post reflecting on the trends and catalysts behind the rapid increase in oil prices. But after receiving feedback from readers, I decided to split it up into three shorter posts that examine each of the long-term trends more in-depth. The following post examines the first trend: dollar depreciation.

As oil prices continued their drop today, falling more than $18 since last Friday, analysts and commentators began to question whether oil is finally in retreat thanks to any one of a variety of pet causes and issues blamed for its dramatic rise.

But much to the chagrin of scapegoaters everywhere, unlike in years past - such as in 1973, when the OPEC oil embargo caused prices to spike - there really isn’t any one central factor that we can squarely pin the blame on for rising oil prices. Instead, three long-term trends that have been converging since the early 2000s - dollar depreciation, tightening global oil supply combined with rising demand, and increasing commodity price speculation - provided the powder keg, while the fallout from the credit crunch lit the fuse that caused oil prices to explode so fast and furiously.

Over the next three posts, I will examine each of these trends in turn - beginning with Congress’s current favorite: the depreciating dollar.

Mind the gap

As fears over Fannie Mae and Freddie Mac recently brought the dollar within a penny of its record low against the Euro, members of Congress have increasingly focused on the depreciating dollar as the source of and solution to all our woes. Witness Congressman Ron Paul (R-TX) informing us at Tuesday’s biannual Humphrey-Hawkins hearing that we don’t need “a world-class regulator that is going to solve all our problems” but rather “a world class dollar - a dollar that is sound, not a dollar that continues to depreciate.”

To be sure, as Chairman Bernanke acknowledged in his testimony, the falling dollar has definitely played a role in oil’s spectacular rise over the last year. To see why, just look at the gap that’s been slowly emerging between the price of oil in dollars vs. gold:

While the price of oil in dollars has nearly doubled, the price of oil in gold has risen by 50% over the same period. This discrepancy becomes an even more jarring 3-to-1 if we turn the clock back to late 2001, when the dollar began its tumble. Small wonder that in January of this year the Financial Times crowned gold as “the new global currency.”

This has led some economists - notably Stephen P.A. Brown at the Federal Reserve Bank of Dallas - to estimate that the depreciation of the dollar is responsible for a large percentage of the rise in oil prices over the last seven years. “If the U.S. currency had held its 2001 value against the Euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price,” Brown wrote in May. And as if that weren’t high enough, in early July - sourcing Brown - New York Times business columnist David Leonhardt cited this gap as $31.

Symptoms of addiction

The dollar depreciation trend only became exacerbated by the onset of the credit crunch, which forced the Fed to slash interest rates at a time when federal banks around the world were hiking interest rates to stem inflation pressures. Consequently, the already-weakened dollar plunged even more and the changes in dollar-denominated oil became even more pronounced.

To see why, think back to America’s “addiction” to foreign oil. The United States currently imports over 70% of its oil as a way to meet its energy needs. During times of elevated oil prices, this dependency leads to large capital outflows from the U.S. to the rest of the world (what Texas oil tycoon-turned-environmentalist T. Boone Pickens called “the largest shift of money in the history of mankind” in a recent interview with the Chicago Tribune editorial board). And just as strong capital inflows tend to strengthen the dollar - as they did throughout the 1990s and early 2000s when central banks around the world were selling their gold reserves and buying up dollars - strong capital outflows tend to weaken it. The result: a vicius cycle in which oil becomes more expensive but the U.S. continues to buy it at a higher price, adding more downward pressure on the dollar, upward pressure on oil, and so on and so on.

Possible cure

Naturally, one way to break that cycle is for the U.S. to import less oil. But as global oil demand from places like India and China surges, decreased domestic demand is unlikely to make a big dent in the price of oil. Oil demand is, after all, highly correlated to income and, as Brown of the Dallas FRB points out, China’s GDP per capita rose from $1,103 in 1990 to $4,088 in 2005 while India’s went from $1,202 to $2,222 over the same period (adjusted for inflation and purchasing power parity). Couple this with the sober fact that non-OPEC supplies of oil have consistently been lower than what the industry has expected and what results is the second long-term trend that’s been driving oil prices higher: tight global supply and demand conditions.

More on this in my next post in this series.

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