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Paper money chasing paper barrels: Why oil prices are artificially high

The cost of oil keeps screaming higher while reports keep showing that demand for oil is down. Even the Saudis admit that their product is overpriced, yet oil and gas markets remain more volatile than ever.

At issue is the fact that the market mania has been driven by two factors: a weak U.S. dollar and speculators trading paper barrels with paper money on the New York Mercantile Exchange (NYMEX) futures market. Let's look briefly at each factor:

Speculators are creating artificially high prices and the illusion of high demand by "flipping" paper barrels.

You've heard of "flipping" homes, right? In a home flip, you buy the home, take possession of the mortgage, and resell it quickly at a profit without even living in it.

Right now, investors are flipping paper barrels of oil. These investors will never take possession of the oil they buy - they're just in it for a quick-and-dirty profit. This flipping of paper barrels has helped create an artificially high price for oil on the NYMEX.

Here's how it works:

NYMEX, or the Merc, is a clearinghouse for barrels of oil delivered one month into the future for WTI oil, which stands for "West Texas Intermediary" oil.

Today, early trading on the NYMEX set the price of a barrel of WTI at nearly $140 a barrel - an all-time hand-me the nitro-and-call-the-paramedics record high.

Now what's important to know about the NYMEX WTI price is that this is the price that everybody in the world watches, even though the amount of oil that is actually delivered or used through NYMEX is a very small amount.

What this means is that when the price of NYMEX oil goes up, it sets off a chain reaction on global oil markets. If the NYMEX price surges, prices will also surge for Brent Crude futures in London. oil futures on the Nikkei, and so on.

None of the traders buying these contracts will ever use the oil they purchase. In fact, most of them have nowhere to store the oil because they are speculators, not oil people. Yet, it is these same speculators who are driving up the price of oil by creating the perception of artificially high demand and artificially high prices.

San Diego recently encountered a similar situation with housing: Real estate agents were buying up multiple condominiums as investments. These investors purchased far more homes than they could live in, believing that they could resell them at fantastic profits. So many real estate agents began flipping homes that it created an artificial demand for housing. Across the street from UCAN, a "condo-flipper" paid nearly a million dollars in 2005 for an 800-square-foot condo on 5th Avenue. The buyer was certain the price would increase. That buyer was wrong. in 2007, the same condo was auctioned off on the street last fall for less than $350,000.

What's important about this story is that our greedy, condo-flipping Realtor helped create a false demand for condos that helped drive up the price. He or she had no intention of living in their new condo. And because of this condo-flipping, real homeowners ended up paying too much because there was a shortage of housing.

The same thing is happening on the NYMEX - the people who are buying the oil have no use for it. They do not own refineries, pipelines, or gas stations. All they own is the paper. They are just like that condo buyer with a mortgage for a home they'll never live in.

And this is where the paper trades get crazy.

According to OPIS, the Oil Price Information Service, on Friday, June 6, more than one million contracts for oil were traded. This represented more than ONE BILLION barrels of crude oil. The numbers are as ridiculous as that overpriced condo we mentioned earlier - one billion barrels of oil is equal to 15 years of WTI production. Paper, not oil, is changing hands. If one billion barrels of oil were actually being delivered in New York Harbor next month, the value of a barrel of oil would drop to about three dollars a unit, gas would cost 78¢ a gallon, and Wall Street would be submerged in about three feet of oil because there would be no place to store it.

Oil prices haven't increased that much, rather the value of the dollar is dropping ...

In November 2002, the Euro and the dollar were almost equal in value: one dollar was equal to one Euro (see graphic).

At that time, NYMEX oil was trading for about $25 US a barrel (or about €25 Euros per barrel). Today, that same barrel of oil costs $131, or about €85 euros (click here for historic conversion rates, click here for historic NYMEX oil prices).

In other words, if the U.S. dollar wasn't being devalued, the price of oil right now would be about $85 a barrel. That means the dollar is inflated by about 154% over the Euro.

This has resulted in "capital flight" away from the dollar into oil. Meanwhile, the relative value of oil has increased because it is worth something, whereas the dollar is being aggressively devalued.

The problem is that the U.S. has been forced to devalue its currency in order to pay its war debts. This is the traditional method that governments use to pay off war debts. By inflating the dollar (i.e. printing more dollars), it allows the government to pay off its debts in cheaper dollars than what were originally loaned. It's sort of like borrowing an ounce of gold from somebody and then paying them back with half an ounce of gold. It's a great deal for the debtor.

This is why inflation has been called the "cruelest tax of all." Strong dollars that were borrowed by the USA are being paid back in weak dollars that aren't worth as much money.

And that's why your gasoline costs so much more than it did a few years ago: Traders are buying paper barrels with paper money.

No wonder Alan Greenspan recently wrote that the current crisis will likely be "the most wrenching since the end of the second world war." (Financial Times)

It all sounds good on paper. But in the real world, the fate of nations is fueled by the the cost of oil, not the value of paper.