What is the relationship between oil prices and inflation?

[gogia]

What is the relationship between oil prices and inflation?

 

The price of oil and inflation are often seen as being connected in a cause and effect relationship. As oil prices move up or down, inflation follows in the same direction. The reason why this happens is that oil is a major input in the economy - it is used in critical activities such as fueling transportation and heating homes - and if input costs rise, so should the cost of end products. For example, if the price of oil rises, then it will cost more to make plastic, and a plastics company will then pass on some or all of this cost to the consumer, which raises prices and thus inflation.

The direct relationship between oil and inflation was evident in the 1970s, when the cost of oil rose from a nominal price of $3 before the 1973 oil crisis to around $40 during the 1979 oil crisis. This helped cause the consumer price index (CPI), a key measure of inflation, to more than double from 41.20 in early 1972 to 86.30 by the end of 1980. Let's put this into perspective: while it had previously taken 24 years (1947-1971) for the CPI to double, during the 1970s it took about eight years. 

However, this relationship between oil and inflation started to deteriorate after the 1980s. During the 1990's Gulf War oil crisis, crude prices doubled in six months from around $20 to around $40, but CPI remained relatively stable, growing from 134.6 in January 1991 to 137.9 in December 1991. This detachment in the relationship was even more apparent during the oil price run-up from 1999 to 2005, in which the annual average nominal price of oil rose from $16.56 to $50.04. During this same period, the CPI rose from 164.30 in January 1999 to 196.80 in December 2005. Judging by this data, it appears that the strong correlation between oil prices and inflation that was seen in the 1970s has weakened significantly.

[gogia]

Peak Oil: What To Do When The Wells Run Dry

by John Hanley

 

During the oil crisis of the 1970s to the rapid rise of oil prices during the early part of the twenty-first century, concerns surrounding the use and availability of this non-renewable resource greatly increased in the minds of many. One theory that always seems to creep up when oil prices rise is the idea of peak oil, which is a hypothetical date at which the world's crude oil production will peak. Every day after this would mean lower production levels and an ever decreasing supply.

 

Simply put, when the world's oil producers combined can no longer increase their oil output, we will have reached peak oil. Oil will be increasingly difficult to find and extract because there will be less of it and fewer deposits to find.

Although the steady depletion of oil is a certainty if we assume oil is a finite resource, optimists don't see peak oil through the doom-and-gloom perspective of some. Peak oil may be decades away, and all the hype in the meantime serves a purpose by spurring progress in setting up alternative energy sources. By the time peak oil arrives, it is hoped that alternative sources of energy will be in place.

While there are as many peak oil proponents as there are detractors, in this article we will look at how you can make money on this potential event.

Peak Oil Implications 
Demand
Demand for oil has consistently risen globally. Should demand continue to rise when total output has reached its peak, basic economics tells us that oil prices will steadily rise with demand. And when production falls - which will occur when oil becomes harder and harder to find - oil prices will rise at a much greater rate. Oil exploration will become much more aggressive, and alternative oil sources - such as Canada's oil sands - will be increasingly exploited to squeeze out every last drop of oil.
Alternative Energy
Alternative energy sources will become much more popular as countries are forced to move to a sustainable energy supply, and as fossil fuels simply become too expensive. The way we live our lives would dramatically change if oil-based energy becomes economically out of reach. For example, people will probably live closer to where they work, leaving municipalities strained in their attempts to provide adequate transit as well maintain social services and infrastructure at a much higher cost.

When and if peak oil does arrive, it needn't be all doom and gloom. It can be a major investment opportunity as there are areas in the market that will benefit. Some of these investment opportunities include:

• Oilfield Services
  As the amount of reserves oil companies hold starts to diminish, oil companies will need to increase oil exploration and drilling to replenish reserves - after all, they are in the business of selling oil. As oil producers increase spending on exploration, it is the oilfield services sector that will win by receiving more orders and seeing higher revenue. Oilfield services companies provide the tools and equipment required in the exploration of oil including drilling rigs, offshore rigs and transport equipment. Therefore, with a dramatic increase in drilling, oil field service companies are likely to be in demand, making them a hot investment.
• The Oil Giants
  Investing in the top guns of the oil industry is a good bet, peak oil or not. If peak oil is reality, the steady decline in supply will drive the price of oil up causing each company's oil inventory to steadily increase in value. This will result in higher valued stocks for these companies. Basically, the higher oil prices are, the more oil and derivative products will be sold, which should increase profits.
• Alternative Sources of Oil
  As conventional oil is depleted and becomes harder to find, oil companies will increasingly look to unconventional sources to boost production. Additionally, higher oil prices brought on by higher demand and lower production make these alternative oil sources financially feasible. The oil sands in Canada and Venezuela are examples of such an unconventional source, where bitumen - a heavy crude oil - is mixed together with sand and clay. This substance is extracted and refined to produce oil.
  
  Oil shale is another alternative. Extracting oil from oil shale - rock containing kerogyn that can be converted to synthetic crude oil - is an even more intensive process than that of the oil sands. Oil shale production is only a viable alternative when oil prices are over $70 per barrel.
  
  Some processes exist that convert coal to synthetic oil. However such methods will likely only be interim alternatives because coal is also a finite resource.
• Alternative Energy
  The most obvious option in the peak oil dilemma is to move to something other than oil for our energy needs. This option isn't yet as feasible. Alternative energy only accounts for a small percentage of energy sources, but the onset of peak oil will force society to look elsewhere to meet its energy needs. If the optimists are right and peak oil is decades away, we have time to develop new technologies to harness alternative energies. But with the hype generated by high oil prices and peak oil speculation, this industry is getting a boost. 
  
  Because such a very small percentage of our energy sources include alternatives to oil, it could be said that the market for these products has nowhere to go but up. Energy sources such as geothermal, solar and wind energy will be sought after as solutions. Additionally, because many of the technologies that harness these energies are built using oil dependent machinery, there will be an additional push to develop technology for this purpose as well.
• 
  Hybrid and electric cars have become increasingly popular in recent years due to high gasoline prices. Expect a greater degree of growth in this area with the arrival of peak oil and higher prices at the pump.
  
  All of the technology required to produce alternative forms of energy will need further research and development to ensure greater efficiency and economic viability. Investments in the companies leading these R&D initiatives will likely bear much fruit. As oil production falls and oil prices rise, research will become more intensive as industry puts both feet forward to develop the next generation of energy technology.

Investments to Avoid
In general, the investments to avoid in a peak oil situation include companies that rely on oil and other petroleum products as a major input cost. For example, transportation companies and airlines are susceptible to price fluctuations in oil and would be hurt by the extremely high prices that would be the result of a peak oil situation.

Conclusion
Peak oil brings with it several opportunities for investors. Whether it's oil, oil field services, or alternative energy, investors can cash in on this phenomenon. But be careful. If we reach peak oil, it will mean dramatic changes to society in the way we live and do business. Watch your investments closely and be sure to adjust to a changing marketplace.