There is a long-held belief that significant increases in oil prices are harbingers of building inflationary pressures.
It follows from the observation that a market able to absorb more expensive oil is also one where prices are rising elsewhere.
And for those who remember their "Intro to Economics," there is an additional element.
Recall that the two primary factors that cause inflation are the amount of currency in circulation and the velocity with which that currency is changing hands.
In the case of the former, the relationship between oil prices and inflation obliges us to apply a somewhat broader view of what makes an underlying "marker asset."
After all, the actual price of wet barrels (traded consignments of actual crude or the products made from it) is driven by the price of paper barrels these days (the futures contracts on those deliveries).
Since there are many more paper barrels than wet barrels, it is the perception of traders on the future price of oil that drives this market not what a delivery costs this morning.
Which leads us to inflation's other component: the velocity of money…
Oil Prices and the Velocity of Money
Let's make this one simple. The velocity of money increases in an environment where participants believe prices will be rising. In this environment, money tends to change hands more quickly causing prices to go higher.
In short, there is less reason to save money if it is perceived that prices will rise faster than any proceeds that could be had from the use of the withdrawn currency. Read here: "The rise in staple product prices will exceed the savings rate."
When it comes to a commodity as energy, so fundamental to economic activity, an increase in velocity will translate into a classic inflationary spiral.
Or at least this is the traditional argument.
Of course, it goes without saying that a pronounced and prolonged price explosion such as the one we experienced five years ago certainly would carry significant inflationary consequences.
At the peak in 2008, price levels did climb as oil rose to an intraday high of $147.92 a barrel and natural gas was pushed $13 per 1,000 cubic feet or million BTUs (the NYMEX futures contract for gas).
Yet the situation we have this time around carries very different dynamics indeed, just take a look:
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.