Posted: October 10, 2013
U.S. oil prices: Let the good times roll
The value of the dollar is keyJim Harden
A funny thing happened on the way to the euro. When first introduced to the global financial markets in 1999, it began to appreciate in value compared with the U.S. dollar (USD). Around this time, West Texas Intermediate crude oil was trading below $20 a barrel. As the dollar lost value, oil began to rise. Is this a coincidence?
The dollar began to devalue against the euro and other major global currencies in 2003, primarily as a result of the Iraq War costs. By year-end 2002, the dollar had weakened by nearly 20 percent and the price of crude had jumped more than 30 percent. Things got no better for the beleaguered dollar from then on.
By December 2004, it was trading at $1.35 to the euro and crude oil had risen to over $43 per barrel. This depreciation continued through the mid-2000’s and as it did, our account balance widened and oil prices climbed with the euro. With the subprime mortgage crises of 2007 and 2008 as a backdrop, the malaise continued, culminating in early July of 2008 when crude reached its historic apogee of more than $146 per barrel. In that same fateful week, the euro hit its apogee of $1.604.
As further proof, the correlation coefficient (which measures the strength of the linear relationship between two variables) between the West Texas Intermediate crude price and the value of the U.S. dollar to the euro, was greater than 0.87 between October 2001 and July 2008, and even higher than 0.90 in several periods before and after the collapse of July 2008.
Drivers of Oil Price
The basic laws of supply and demand are simply stated as:
- If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.
- If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
- If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price.
- If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price.
The major factors that drive oil prices are (1) the global economy, primarily the U.S., the European Union and China; (2) energy scarcity, including reserve accretion and depletion; and (3) purchasing power, expressed in the respective currencies of those countries, with the heaviest influence from the U.S. dollar.
Because a large majority of global oil is traded in U.S. dollars, the volatility of that currency has tremendous influence on the real price of oil. Any weakness in the value of the USD against other currencies increases the purchasing power of countries that are not USD denominated.
For example, if the value of the dollar is even with the euro, then, all things being equal (crude qualities, transportation, and supply/demand), the cost of a barrel of crude oil would be the same for parties transacting in dollars or euros. However, if the dollar strengthened, then it would require more euros to purchase a barrel of oil. The reverse situation is not only true, but has been exhibited for the past several years; whereby countries denominated in the euro pay less for a barrel of oil in dollars.
So a weakened USD is a key driver of higher oil prices. It doesn’t diminish the role of supply and demand, but it is of equal importance. The question then becomes what is the dollar’s outlook and what corresponding effect would it have on oil prices, and therefore revenue and profit for oil companies? Let’s look at two scenarios.
Low Price Cases
In June 2013, the World Bank said that “… over the longer term, oil prices are projected to fall.” Your case for lower prices would argue that the EU economy is worse than thought and that the U.S. economy strengthens more than forecasted. Also in June 2013, the European Central Bank had a dour assessment, once more revising downward their GDP outlook. According to The Economist, “The protracted weakness especially in southern Europe is inflicting social misery.” [They] went so far as to proclaim that “… the most corrosive of all is loss of hope as the lost decade continues”.
Jim Harden is a partner/principal and the valuation services leader at Hein & Associates, a full-service accounting and advisory firm with offices in Denver, Houston, Dallas and Orange County. With more than thirty years of experience in the energy industry, including as an independent oil and gas operator and petroleum geologist, he provides valuation, economic consulting and expert witness services to energy companies, private equity and law firms. He is a Senior Member (ASA) of the American Society of Appraisers, certified in oil and gas valuation. Jim can be reached at 713-600-7423 or at firstname.lastname@example.org.