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Jewish World Review Nov. 20, 2001/ 5 Kislev, 5762

Lawrence Kudlow

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Whose side are they on? -- "EITHER you are with us, or you are with the terrorists," President Bush told the U.S. Congress on September 20. It was a new paradigm that rallied the U.S. and democratic nations all around the world.

And it is a policy benchmark that should be used in judging the latest Saudi attempt to curtail OPEC oil production and raise oil prices. Most of the global economy is in recession, and too-high oil prices in 2000 was an important contributing factor. Should OPEC succeed in raising oil prices again, then recovery hopes for next year would be dashed. The worldwide coalition against terrorism would be weakened.

The lack of wartime cooperation by Saudi Arabia stands in stark contrast to the actions of Mexico and Russia. Spokesmen for both of these non-OPEC oil producers explicitly referred to the need for political and economic cooperation with the U.S.-led war against terrorism as a reason for not playing ball with OPEC. Naturally, Mexico and Russia have their own commercial interests to look after. Increasing their share of the world oil market clearly motivates their thinking. But a political willingness to work with the U.S. is no small factor in their decision. It's a welcome decision.

Saudi oil minister Ali al-Naimi says that the oil market has entered "crisis mode", and he keeps raising the worst-case scenario of $10 a barrel, a level that could halt new energy investment and production. But very few oil players believe that $10 a barrel is likely to happen. In fact, most oil analysts believe that prices in the mid- to high-teens is more likely.

Actually, today's $17 a barrel oil price looks to be just about right in terms of two economic models of oil price behavior. First, the inflation-adjusted real price of oil has averaged $21.50 a barrel over the past decade. Real prices moved temporarily to $45 during the Persian Gulf War, and briefly fell to $10 a barrel in late 1998 during the global financial crisis that threatened world deflation and recession. The most recent spike was slightly above $30 a barrel this year. Currently the real oil price is $16.50.

Second, a monetary model of oil prices that uses the ratio between gold and oil suggests that today's $17 per barrel spot price for West Texas crude is also just about right. Gold is a useful benchmark because its monetary purchasing power is relatively constant over long periods of time. Hence an ounce of gold should over time buy roughly the same number of barrels of oil.

Over the past decade an ounce of gold bought seventeen barrels of oil, on average. Today, at $275 per gold ounce, $17 a barrel of oil implies 16.2 barrels per gold ounce. This is actually below the average of seventeen oil barrels per ounce of gold registered over the past decade.

Therefore, a $16 per barrel oil price would be consistent with the decade-long trend. So the Saudis are wrong. In constant gold dollars, oil should decline a bit more in order to maintain the long-term trend of $17 barrels per gold ounce.

Rather than splitting hairs, the Saudis ought to just leave the world market oil price alone. In terms of gold, the oil price is just about right. In terms of the $21 long-run real price of oil, the spot market looks a bit cheap. However, when productivity-enhancing technology advances for exploration, drilling and production are factored in, the trend price of oil should be coming down.

In West Texas, for example, production costs have dropped to the $6 to $10 range. In Saudi Arabia's repressed economy, the marginal cost of oil production is estimated to be only $2 to $3 a barrel. So there's plenty of profit in $17 a barrel.

These calculations make the Saudi goal of $25 a barrel look mighty suspicious. Current oil prices are about 40% below the inflated level of a year ago, and most economists believe the tax-cut effect of lower energy will promote world recovery next year.

However, a near 50% oil hike, as proposed by the Saudi-dominated OPEC, will sink recovery hopes. Whose side in the battle against terrorism are the Saudis really on?

JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


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