A hard look at the current price of oil and gasoline

Everyone's talking about the price of oil, and why not? With gasoline prices above $4 per gallon in many parts of the country (this photograph was taken this week at a gas station in the San Francisco Bay Area), the cost of driving has increased tremendously in a few months.

With crude oil futures contracts currently above $135 a barrel, many consumers are blaming the oil companies, while many investors are tuning in to dire prognostications about "peak oil" and reasoning that a dwindling supply in the face of rising demand will send oil prices on a continual upward spiral. But before you decide that oil is the one investment that will "always go up and never go down," remember that just a few years ago many people were saying the same thing about real estate, and consider whether the current situation might just be related to the the credit and housing speculation that recently collapsed with such disastrous consequences.

Skyrocketing oil prices are related to skyrocketing gasoline prices, which create a cost that people cannot ignore, since they have to fill up about every week or two weeks. The cost of driving has risen by $890 per year for the average driver of a Ford Explorer or Toyota 4Runner logging 20k miles, according to the AAA's annual "Your Driving Costs" report, up about 23.4% for drivers since 2007 and up about 40% over the past two years.

Congress, fearing a groundswell of resentment from their constituents, promptly pounced on the oil companies, grilling oil company executives recently in Washington and telling them they "apparently have no ethical compass about the price of gasoline" (in the words of Senator Diane Feinstein). Senator Dick Durbin asked them, "Does it trouble any of you when you see what you are doing to us, the profits that you are taking, the costs that you are imposing on working families, small businesses, truckers, farmers?"

But ire directed at the oil companies is misplaced: oil companies want nothing more than to deliver more oil (and oil refined into gasoline) to consumers, because by doing so they make money. The record clearly shows that Congress has imposed excessive regulation on their industry and erected barriers to the ability of private companies to operate, including the placing of vast areas of land and territorial waters off-limits to exploration and drilling, restricting the construction of pipelines and refineries, and mandating wasteful programs such as ethanol requirements. In 1995, Congress did pass legislation opening up the Arctic National Wildlife Refuge for exploration and drilling, but the President at the time vetoed the bill.

Further, government taxes per gallon of gasoline have risen sharply, and are currently at about 14.7% of the price per gallon for regular gasoline pictured above (Federal and state combined). As others have noted, this percentage is higher than the profit margins of the oil companies that the Senators were excoriating and calling unethical.

The real culprit in the current price of oil has been excessive Fed easing, which has lowered the purchasing power of the dollar dramatically over the same period that the price of oil has been rising. While this latest run-up has unleashed a chorus of pundits who argue that we have reached "peak oil" and begun the inevitable decline into oil shortages and higher prices, we would point out that the recent advance of oil prices has corresponded to a period of remarkable Fed easing, beginning with the reduction of interest rates to 1% for thirteen months from 2003 to 2004, and followed by the current easing period.

We discuss the mis-allocation of capital that Fed over-steering has caused in the past ten years or so in previous posts, such as this one. We would caution that the current price of oil (and of gasoline) is a by-product of the same Fed policy that has caused dollars to shrink rapidly (see this previous post for further discussion of that subject).

As we have stated many times before, we advocate building the foundation of your future wealth upon the same bedrock that has proven to be responsible for most of the big fortunes made in this country over the past one hundred or more years: the ownership -- for a period of years -- of shares in well-run businesses that are positioned in front of fertile fields of future growth. Trying to "play" the run-up in oil, which is caused by political and monetary factors that have little to do with the long-term fundamentals of business and which can reverse rapidly, is a shaky foundation for building long-term wealth and one we would strongly caution against.

For later posts on this same topic, see also:

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