The Fed, and why $105 oil prices may be a bubble

President Barack Obama says demand is at the heart of oil prices — the global economic recovery, he told an audience yesterday at Georgetown University, is responsible for tripling the price of oil from the dregs of $32 a barrel in fall 2008 to more than $100 a barrel now.

Not so, says Phil Flynn, an oil trader at PFG Best whose stuff I follow — Ben Bernanke is to blame. Flynn has been saying this for a long time — specifically that the federal government’s economic stimulus, and most recently the Federal Reserve’s irritatingly named policy of "quantitative easing," are behind the swelling that we observe in our fists as we shake them in anger while filling up at the pump. He repeated this again two days ago on his blog.

Finally, I decided to ring Flynn and ask what on Earth he means. Read on for his reply, and why oil prices may actually be heading back down.

First, some background: According to SourceWatch, the total of the federal money disbursed — the bank bailouts, the mortgage relief, the purchase of mortgage bonds, plus the Fed’s purchase of U.S. Treasury bonds from banks (otherwise known as quantitative easing) — has been about $4.7 trillion since fall 2008. The Obama administration said this week that the original portion of the money — the $700 billion TARP program signed by President George W. Bush, plus the $787 billion approved on Obama’s watch — will end up costing taxpayers just $25 billion because most of it has been paid back or the assets sold.

Yet the economy is still lethargic. The Fed is keeping interest rates at about 0 percent. On top of that has come the stimulus programs of the rest of the world. So all this spending, and the easy money, is effectively producing a negative interest rate. It is like throwing sacks and sacks of dollars in the air at a casino.

So, again, why is this set of facts responsible for higher oil prices? One simple reason, says Flynn, is that the stimulus, low interest rates, and quantitative easing have been to a large degree successful — barely anyone any longer believes the entire global system is about to go down the toilet, and the U.S. economy is growing again. Indeed, the global economy is growing, especially China’s. Buildings, cars, and all kinds of stuff are being built; some of it is even being bought. The factories producing these goods require oil in order to operate. And so there has been the rise in oil demand that Obama cited, though fired up by government spending.

But Flynn says that ginning up oil prices even more is that, when you put a lot of money out there, people and entities that have it in their hands look for the most profitable place to put it. In this case, that’s been the world’s emerging markets, especially Asia, which can really put it to work with those big construction projects and so on. So the concentration of those trillions in the emerging economies has supercharged demand, and oil-buying.

The Fed has a rationale for this action. Not only is it stimulating economic activity, but it is desperate to keep the U.S. economy from reversing course into the sphere of another dreadful, jargonistic word — deflation. That would be the tailspin in which Japan has been for a decade, a price-drop spiral that discourages the economic growth you need so young people get new jobs, and we get higher salaries.

But a party can’t last forever, and the Fed will sometime have to take its foot off the accelerator. That’s when Flynn sees a significant possibility of oil prices plummeting, even with the political disruption going on in the Middle East.

Taking stock of where we are, I asked Flynn how much of the rise from $32 a barrel to today’s $105 a barrel the Fed and the federal government are responsible for. "You could almost make the argument that 90 percent or 100 percent is due to the stimulus, because no one knows whether the economy would have gone into a double-dip recession without it," he said.

How far oil prices could drop depends on how steady demand stays after the end of stimulus programs, and whether the Arab Spring results in more oil supply disruption, or even which countries are next to be roiled. If Oman keeps having trouble, that’s not a big deal; if it’s Saudi Arabia, it is.

Flynn thinks there could be significant air in the price — "if you believe that the stimulus saved the global economy, you have to say $50 a barrel," Flynn says.

Speaking literally, that would mean roughly $55-a-barrel oil, which given the news seems unlikely. Prices can be sticky going down. But a significant drop in prices — by $10-a-barrel or a $20-a-barrel? That is not hard to imagine.