Oil prices hit record

In recent weeks oil prices have been setting record highs. Record spot prices for West Texas Intermediate were set each day last week including Friday’s settle price of $83.42. This is in sharp contrast with a cycle low of just over $10 per barrel in 1999.

Since 1999, oil prices have risen eight-fold.  But oil prices have “only” doubled since the previous long-term high of $39.50 per barrel in July 1980 (monthly average).

Inflation adjusted oil prices still below peak

How do oil prices compare when adjusting for the average level of inflation. That is, what is the cost of oil when compared in constant dollars? The prior long-term peak of $39.50 per barrel is the benchmark for comparing whether current oil prices are higher or lower in inflation adjusted dollars. So, for an inflation adjusted comparison, the consumer price index is rebenchmarked so that the index equals “1” for July 1980.  Then the current dollar oil prices are divided by this 1980 indexed CPI. The chart below shows inflation adjusted oil prices in the U.S.

Based on inflation adjusted oil prices, current oil prices are still substantially below the peak of $39.50 per barrel set in July 1980. Using July 1980 dollars, the September 21, 2007 current dollar record high of $83.42 per barrel translates to only $33.09 per barrel in July 1980 dollars. In inflation adjusted terms, we are still 16 percent below the record high set in July 1980.

Dollar denominated oil is affected by exchange rates

What many in the U.S. forget or take for granted is that oil is generally sold and bought with U.S. dollars. Changes in a country’s exchange rate can significantly affect that country’s cost of oil. And we have recently seen that the dollar’s ongoing decline has affected oil demand overseas. But before getting to that, let's look at how exchange rates impact a country’s cost of oil.

One country that has seen significant long-term exchange rate based changes in the cost of oil is Japan. The Japanese/U.S. exchange rate has gone from about 300 yen per dollar in the mid-1970s to currently about 115 yen per dollar. This long-term decline in the dollar versus the yen has softened dollar denominated increases in the price of oil for Japan.

In fact, the price of oil in yen is still below the long-term peak set in 1980. This is in sharp contrast to current dollar prices for the U.S. being twice as high peak to peak.

In inflation adjusted yen, the price of oil currently is still approximately 25 percent below its April 1980 peak.

Recent declines in the dollar have put upward pressure on oil

Since early this year, the dollar has fallen significantly against a number of currencies – with the recent interest rate cut by the Fed adding to that trend. Notably, the dollar has fallen 4.3 percent against the euro since the Fed’s August 17 cut in the discount rate.

Looking at daily data on the price of oil and the euro/dollar exchange rate, there is a strong correlation between the drop in the dollar since August 17 and the rise in oil prices. Certainly, there were other factors but the relative drop in the price of oil in euros (and other currencies) has boosted foreign demand for oil. This is good for foreign purchasers of oil but not good for U.S. purchasers. Additionally, oil producers have an incentive to keep the dollar price of oil up – the producers are not receiving revenues that are as valuable to them as when the dollar is strong.

In recent weeks, the gap between the price of oil in dollars versus in euros has widened due to the decline in the exchange value of the dollar.

Bottom Line

Oil prices are up but not as high in real terms as in 1980. This is one of the reasons the U.S. economy has not been hurting as much from recent oil price increases. For the immediate term, however, the lower exchange value of the dollar is keeping upward pressure on oil prices. This is an additional channel through which a weak dollar may be fueling domestic inflation.