The demagogues now vying to become President of the United States turned their attention to the economy this week. Barack Obama suggested that middle- and low-income families get another round of rebate checks from the government. American politicians, finding it harder to buy votes with promises, are resorting to buying them with cash.

Obama (and Hillary) suggested that the rebate checks be financed by a windfall profits tax on oil companies. That is just sad. Taking money from oil companies and giving it to middle- and low-income families will do absolutely nothing for the economy as a whole. Oil companies will have that much less money available to search for, and develop, new oil fields while low-and middle-income families will have $1,000 to tie them over – not an amount that will make a long-term difference.

As I wrote in my previous article about the oil price (Sue OPEC), the only thing more sad than the general lack of basic economic understanding among politicians is the severe lack of knowledge among the population that compels them to vote, time and again, for candidates and policies that ensure the deterioration of their living standards, while simultaneously sacrificing their civil liberties “in the name of freedom”.

When I wrote that article I used M3 as a proxy for the money supply. I now have the actual US money supply (AMS), so I decided to take another look at oil.

Herodotus wrote that asphalt was used in the construction of the walls and towers of Babylon approximately 4,000 years ago, but it wasn’t until the ubiquitous use of the internal combustion engine created unprecedented demand for petroleum products that oil became of great strategic importance.

In 1862 the German inventor, Nikolaus Otto, designed an internal combustion engine that was more efficient than any other available at the time. Engines then were stationary and not yet used for transport; Otto’s designs paved the way towards an automobile industry. In 1870 Siegfried Marcus put the first mobile engine on a handcart in Vienna. In 1876 Otto, Gottlieb Daimler and Wilhelm Maybach developed a practical four-stroke engine, based on Otto’s designs. Karl Benz created a two-stroke engine using Otto’s designs in 1879, and later built his own four-stroke engine that was used in his automobiles, which are generally regarded as the first automobiles to be produced. Dr. Rudolf Diesel developed a compression-ignition engine (Diesel engine) in 1892. In 1896 Karl Benz developed the boxer engine (still used by Porsche today) in which corresponding pistons reach top dead center at the same time, thus balancing each other’s momentum. In 1900 Maybach built an engine at Daimler Motoren Gesellschaft based on the specifications of Emil Jellinek, who required that the engine be called Daimler-Mercedes, after his daughter, and in 1902 Daimler-Mercedes automobiles were put into commercial production. The rest, as they say, is history.

Even so, it wasn’t until 1908 that cars became widely used with the introduction of Henry Ford’s Model T. Ford invented the production line and reduced the cost of automobiles sufficiently to make them affordable to the general public. This, perhaps, then also marks a milestone for the oil market.

The oil price was quite volatile from 1908 to 1913 and initially fell with the onset of the First World War in 1914, but rose quite dramatically during the later years of the War. A combination of post-war demand for petroleum products, combined with a large increase in dollar inflation courtesy of the newly created Federal Reserve Bank, pushed oil prices higher. In 1920 the oil price reached $3.46, almost 400% higher than it was in 1908.

Then came the Great Depression and the Second World War, both of which make an evaluation of the oil price difficult. The onset of the Great Depression reduced oil demand and the price fell 47% in 1931 alone, after which it gradually recovered. The devaluation of the dollar in 1934 caused a 54% increase in the oil price during that year. During the Second World War, the Texas Railroad Commission froze the oil price and restricted the number of days that wells could produce.

Post World War II demand for oil increased rapidly and significantly. The Texas Railroad Commission ceased price controls in July 1946 and the oil price increased from $1.17 to $2.57 a barrel by 1948. In 1947 the Commission ordered no shutdown days for the first time in eight years. The demand for oil in the United States exceeded domestic production and the US became an importer of oil in 1948, despite record domestic production levels.

The surge in oil demand and concomitant increase in the oil price spurred exploration and development of new and existing fields, and the construction of new pipelines tied those fields into the distribution network. The oil market appears reasonably well balanced between 1948 and 1970: the average price during those years was $2.88 a barrel and the oil price increased steadily and gradually from $2.57 in 1948 to $3.23 in 1970. But the calm is misleading, and the hand of the Texas Railroad Commission is visible, as the price was exactly $2.57 for five years, $2.82 for three years and $2.97 for five years during that period.

The Texas Railroad Commission controlled the oil price in the United States until 1974 when the oil embargo demonstrated conclusively that pricing power had permanently shifted to OPEC. OPEC, however, was never as effective at controlling the oil price as the Texas Railroad Commission since it lacked enforcing power and relied instead on Saudi Arabia’s ability to flood the market with oil, a strategy that never really worked.

Oil is priced in US dollars so the obvious place to start is the price of oil versus the supply of US dollars. This comparison is valuable since an increase in the supply of US dollars (inflation) decreases the purchasing power of said dollars, resulting in increases in the prices of goods and services. In the following chart we see the oil price and the Actual Money Supply of US dollars.

This chart gives us a quick visual confirmation that the increase in the oil price is not totally out of line with the inflation of US dollars. Perhaps we should not be surprised to see oil above $100 a barrel, and perhaps instead of pointing the finger at speculators and oil companies, Washington should look towards the Federal Reserve Bank for culprits.

Such an analysis is very rudimentary and doesn’t tell us much more. It can also be misleading since the oil price and money supply graphs were not indexed or calibrated. It is merely a visual confirmation that inflation played a large role in oil’s price increase over the past hundred years, or so.

If we remove the effect of dollar inflation from the oil price we will be able to see what the real oil price has been doing. This would be a substantially better gauge of the oil market itself. In the following chart we again have the oil price but instead of looking at the money supply we have the oil price adjusted for inflation.

The real oil price has been falling since the beginning of the last century. Even at $114 a barrel, which is the average price so far this year, oil is 65% less expensive than it was in 1901.

On further analysis we can notice a few more things: the rate of decline in the real oil price was very steep from 1901 to the end of the Second World War but much more gradual from then onwards. In fact, from the end of the Second World War until now it is difficult to be sure whether the average real oil price has declined at all. We do, however, notice that the oil price started rising dramatically since 1998 in nominal terms and we also notice that 1998 was the all-time low for the oil price in real terms.

The 660% increase in the nominal oil price from $14.60 a barrel in 1998 to $114.43 a barrel this year appears to be a very material event. Even in real terms the oil price increased a significant 270% since 1998. But in real terms the oil price fell by almost as much from 1949 to 1998, so how significant is it really?

In the long term the oil price has been declining in real terms for more than 100 years but we can not realistically expect the real price of oil to continue declining: oil consumption keeps rising and we know that it is a natural resource with limited supply. Could the bottom in the oil price during 1998 represent the real low in oil prices? If peak oil is behind us then 1998 may very well represent the all-time low in the real price of oil.

We can also look at the oil price in terms of gold. The most common way of doing this is to divide the gold price by the oil price, which tells us how many barrels of oil it takes to buy an ounce of gold. People who watch this ratio are quick to point out that it took more than 40 barrels of oil to buy an ounce of gold in 1900 while it takes less than 8 barrels of oil to buy an ounce of gold today. The ratio of oil to gold is the second lowest in recent history; oil was more expensive relative to gold only in 1920.

While this ratio has been used many times to express the price of oil relative to gold, the inverse of the ratio is actually more intuitive as it expresses how many ounces of gold it takes to buy a barrel of oil. This ratio of oil in terms of gold is comparable to the price of oil in US dollars for instance, which is much more useful when we view gold as money, as I do.

When we start thinking of oil in terms of gold ounces and treat gold as money then it should also immediately become obvious that we need to adjust the oil price in gold for gold inflation, just as we had to adjust the oil price in dollars for dollar inflation before it revealed the real oil price. If we do not adjust the oil price for gold inflation we’ll never be able to discern whether the change in the oil price is due to supply-demand imbalances or merely inflation.

The inflation adjusted oil price in terms of gold ounces has been added in the following chart.

Overall, the real oil price in terms of both dollars and gold has declined over the past 108 years. In terms of gold, the real oil price is just under its average since 1931, but in terms of dollars, the real oil price is 30% higher today than its average for the same period. Should the real oil price return to its average since 1931 in terms of both oil and gold, the nominal oil price will drop to around $87 a barrel.

As an aside, if that happens, gold would be priced at $727 an ounce. That is remarkably similar to the conclusion of my gold model, which showed that gold should be trading around $757 an ounce.

On the other hand, if the bottom in 1998 reflects peak oil, then the oil price should continue to go up in all measures.

What the above analyses demonstrate is that oil is not at all very expensive today in real terms, either in gold or dollars, compared to its historical price levels. The increase in the nominal oil price during the past 108 years is predominantly a result of the loss of buying power of the US dollar due to inflation -- an increase in the supply of dollars. In real terms it is hard to say whether oil is over-priced or just bouncing off an all-time low price it reached during 1998.

A few months ago BP released its annual oil statistics. Proven oil reserves at the end of 2007 were 1.6 billion barrels less than 2006, or 0.13%. Perhaps this is meaningful, but I have so little confidence in the proven oil reserves published by large oil companies that I would rather look for other clues as to the future of oil prices. Nonetheless, it is possible that this decline in proven oil reserves prompted some speculators to buy oil contracts.

According to BP, world oil consumption increased 1.1% in 2007 while production declined 0.2%. This is much more telling in my opinion, since consumption increased during a year of steeply rising oil prices yet production declined, which I am sure was not due to a lack of will to produce oil, but rather a lack of capacity to produce more oil. This data would further have enticed speculators to buy oil. Both falling reserves and falling production also support the notion that we may be past global peak oil, and that is a powerful reason to be long oil.

On the other hand, the high oil price has caused severe demand destruction. Car manufacturers are reeling as sales plummet and consumers are not just complaining about oil, they are actively changing their behavior to reduce oil consumption. US oil imports during the first six months of this year are the lowest since 2003. Demand for oil in the US fell 3% compared to the first six months of last year and since the US accounted for 24.3% of total demand last year, this translates into a 0.73% decline in world oil demand. And keep in mind that consumer behavioral changes are only now beginning to have an impact on demand.

The high nominal oil price in conjunction with slowing economic activity are going to continue to curb oil demand for a while. Short of a military conflict involving Iran, Saudi Arabia or Russia, I see no reason to believe the oil price can sustain its current levels, peak oil or not.

Some people may think that dollar inflation will continue to drive the oil price higher. This is a dangerous notion because reduced oil demand and consumer behavior will be much stronger influences on the oil price in the short term. Combined, these forces could drive the oil price even lower than $87 a barrel.

If I had to make a bet on the oil price today I would say that it’s more likely to continue to fall rather than rise, in spite of the fact that oil is not that expensive in real terms or that we may have passed peak oil. In the short term, it’s the economy and consumer behavior that matters most and I cannot stress that enough.