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September 7, 2008
The price of oil has skyrocketed in 2008 and even back into 2007. Considering
that oil prices are pegged to the dollar, the fluctuating value of the US dollar
has played a significant role in oil prices. When the US dollar depreciates,
international oil producers – who all sell their barrels in US dollars
– see their profits suffer from the currency conversion. Subsequently,
to offset this reduction, oil producers inflate oil prices accordingly –
which is for the most part what we have witnessed in 2008. There more to oil
prices than just the strength or weakness of the dollar, but they do correlate
to a great extent.
The price of oil has skyrocketed in 2008 and even back into 2007. Considering
that oil prices are pegged to the dollar, the fluctuating value of the US dollar
has played a significant role in oil prices. When the US dollar depreciates,
international oil producers – who all sell their barrels in US dollars
– see their profits suffer from the currency conversion. Subsequently,
to offset this reduction, oil producers inflate oil prices accordingly –
which is for the most part what we have witnessed in 2008. There more to oil
prices than just the strength or weakness of the dollar, but they do correlate
to a great extent.
Inherently, the relative price of oil has an inverse relationship with the
valuation of the US dollar. The price of oil will inevitably rise with a falling
dollar. Taking a closer look at America, who is a significant net importer of
oil, a weaker currency leads to a higher relative cost of oil.
Oil Prices Driven by Market Emotion More Than Lack of Supply
Some experts argue that monetary policy determines both the dollar’s
value and commodity prices. After all, oil is a storable commodity, and therefore,
subject to price pressure created from monetary policy expectations. Speculators
can profit from these expectations and push crude futures higher if they know
that the Fed, for instance, was planning to cut rates (thereby devaluing the
dollar).
Speculators make up the bulk of the market in oil futures. Recent hurricanes
like Gustav and Fay have helped speculators profit greatly by creating a fear
of an oil shortfall. But if you analyze the oil inventories during the past
two hurricanes, they have actually increased, signaling there is more than sufficient
inventory to meet demand.
Subsequently, the idea of having scarcity in resources is not the question.
Unfortunately, it is the fear – not the reality – of scarce resources
and dwindling supply which has been one of the reasons why oil prices and speculation
has risen dramatically. Combine this market psychology with the weak US dollar,
and you have a ripe situation for oil prices to skyrocket which has happened
over the past year or more.
The following are the crude oil and dollar index rate for the past 12 months.
You can see that as the dollar has become weaker the price of oil has risen
dramatically, and as the dollar has strengthened in the past several months,
the price of oil has retreaded.
Fundamentals of Supply and Demand Come into Play
Compounding the problem of the weaker US dollar is the fundamentals of supply
and demand. The roles of OPEC and Saudi Arabia continue to play a factor in
the pricing of oil. Traders perceive that only OPEC and Saudi Arabia can increase
production of oil in the short term, and simultaneously, it is in their best
interest to collude and support a higher oil price to offset the weakening US
dollar – which results in greater revenues for OPEC and other oil producers
like Russia.
However, as the course of history has demonstrated, it is difficult for OPEC
to maintain a fixed price; economically speaking, it is always in the best interest
for the individual states to break away from the price point to increase their
sales volume. In addition, there are so many other forces at work, including
the industrialized nations’ desire to move towards alternative fuels,
that it becomes more difficult for OPEC to successfully collude. OPEC walks
a fine line in maximizing revenues and profits vs. killing the proverbial “Fatted
Calf.”
Indeed, recent demand from huge growth countries, like China and India, has
compounded the rise in oil prices. China has a positive supply side tax policy,
and its growth has been tremendous over the past year. However, many experts
feel that China’s high-paced growth is unsustainable over the long-term,
and in fact, some predict that China’s growth rates will fall to below
10% in 2008 – after following a 13-year stream of expansion. This slowdown
may help reduce pressure on oil prices.
Oil vs. Dollar Prophecies
Oil futures speculators are no strangers to prophecies of per barrel pricing.
There are some analysts that believe that over the longer term oil prices may
continue to drop until it stabilizes in the $80 per barrel range. For now, it
seems to be consolidating in the $105 to $115 range with some volatility as
the overall market is buffeted by regional conflicts, seasonal hurricane challenges,
and political conflicts.
And what is to come of the US dollar? The Fed continues to be hawkish about
interest rates, which have already served to strengthen the dollar. The dollar
index has increased since its collapse in March 2008 and is now hovering around
77 (up from a low in March of 70). It is believed that the Federal Reserve will
cautiously begin raising interest rates to reign in inflationary trends, but
severe interest rates hikes are not probable if oil prices moderate and stabilize
as the Fed does not want to put the breaks in growth and credit availability
in a market where real estate and the banking industries are in trouble, and
unemployment is the highest in five years.
It’s hard to believe the dollar index hit 100 in 2003, when oil prices
were around $31 a barrel. Will we reach those levels again? With the factor
of inflation coming into play, the chances are highly unlikely. However, the
trend towards stabilized oil prices and a higher value for the dollar has already
begun. A stronger dollar will slow down imports some which has been keeping
the economy going during the weak dollar days, but overall balance between export
competiveness and domestic strength and consumption will likely moderate the
strength of the dollar and the price of oil. Time will tell.
What's the Good News of High Oil Prices?
Finally, there is some good news from the high price of oil recently. It gave
consumers and manufacturers a rude wake up call. They understand now that long
term they need to change how they do business to make more efficient use of
resources, invest in more fuel efficient transportation technologies, look into
alternative energy sources, and think about waste and how we can recycle and
reuse our resources and save our planet’s finite and precious resources
and finally help heal our earth by reducing carbon emissions and saving energy
by simply changing out light bulbs to more energy efficient lighting products.
I may not be around in 100 years, but maybe they will look back and say that
the skyrocketing oil prices of 2008 spurred a growth in how the earth views
its resources and we turned the corner on trying to fix our planet.
Along the way, investors will be able to find many ways to profit from the
growth of alternative energy sources, more energy efficient vehicles and battery
technologies, rebirth of nuclear energy, and many other industries that will
thrive meeting the challenges of developing the next generation technologies
that will grow these industries.
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