Separating the US Dollar from the Price of Oil

Oil drilling rig and cattle in field
J Reader, President of Barchan Advisory Services Ltd. ©

As Barchan pointed out in an earlier note in mid-January, the appearance of oil price change is often clouded by changes in the underlying value of the US dollar in which oil prices are usually quoted. In principle there could be circumstances where the apparent oil price has changed and it is nothing but a change in the US currency value. Under these circumstances, the change in “price” tells you absolutely nothing about the supply and demand balance that actually dictates the true value of oil.

The challenge is to separate the foreign exchange from the other factors of interest. Required is a way of measuring the changes in the value of the US dollar as capital flows force it up and down. It used to be that currencies were locked to the value of gold which was considered the ultimate perfect money standard – consistent, divisible, and in relatively scarce supply. Gold can no longer be used as a standard as it is subject to its own speculative ups and downs, and it can be argued that it is not in short supply.

The US dollar can be compared to other currencies, but this is fraught with complexities as well. For example, suppose the US dollar is measured against the Euro today. One of the key reasons why the US currency has attracted buyers recently, is because of the potential break up of the Euro due to the Greek crisis and other difficulties of Euro member states. It doesn’t help to try to measure the relative impact of investors bailing out of one currency and into the other.

It makes no sense to use a currency that belongs to a “petro-state” or any other country that is overly affected by resource development, since the very signal that we are trying to isolate will be buried in the noise associated with the commodity price change. You can’t rely on any controlled economy currency such as China’s, as central bank interference will undermine any true market signal. So-called baskets of currencies create a mélange of these inherent problems.

Barchan has found that a good surrogate for ideal money in the last decade is the Swedish Krona. Although Sweden is not a global powerhouse, it does have a very strong and consistent economy with relatively stable politics. It trades with the Euro zone, but not exclusively – it also trades with Russia and North America. Its trade flows are a good mixture of industrial and consumer products, with some timber and iron resources. It does not produce significant quantities of other primary resources and virtually no hydrocarbons. Sweden also has a strong bourse and banking system that is quite independent but at the same time capable of seamless currency flows.

Below is a chart showing two important trends. The first is oil price deviation in US dollars per barrel since beginning of 2011 – a relatively stable pricing environment until the last six months or so. Also shown is the deviation in the value of the US dollar denominated in Swedish Krona over the same period. The average from the beginning of 2011 until May 2014 is used to calculate the deviation in percent.

image-n8-1

The quick observations are striking. First off, the early period is one of remarkable stability on average. There are deviations but they are generally within 10% of average and show a strong tendency to revert toward the long-term mean. Second, it is pretty obvious that the oil price has fallen to 50% of its three and a half year mean and all within about six months. This is clearly dramatic and unusual.

What this article is driving at here however, is the underlying change in value of the US dollar. Against the Swedish Krona the US dollar has appreciated 25% in six months. There has not been any dramatic change in the Swedish economy to account for this change. Rather it is a flood of global capital into the US currency that has caused this and it has a profound impact on our perception of the change in oil price.

Let’s assume that the stable US dollar oil price had been $100 per barrel (WTI). Suddenly the value of the US dollar jumps 25%. This means in “new dollar” value terms, the price of oil will appear as $80 per barrel. In other words the first $20 per barrel of the recent decline in oil prices as widely quoted has not the least thing to do with oil market fundamentals. It is in fact, an artifact of currency speculation.

In summary, the oil price collapse observed over the last six months or so has been in real terms not nearly as significant as a perusal of US-denominated WTI price quotes would suggest. The first $20 per barrel of the decline is due to floating currency. The next $30 per barrel is due to something else. It’s worth noting that the $30 residual is really about $37.50 per barrel in “old dollar” terms – significant no doubt, but it leaves us with less of a differential to account for due to other causes like supply and demand fundamentals for example. We’ll comment on the supply and demand element in a later note.

A Post-Script for Canadian Readers

One of the more silly things that Canada’s central bank has done recently is to intentionally de-value the Canadian dollar by unexpectedly and unnecessarily dropping the central bank lending rate in January 2015. The central bank couldn’t really articulate why they did this, with Governor Poloz commenting vaguely about “insurance”, presumably against an economic downturn.

Barchan speculates that this move was an attempt to artificially boost the Canadian dollar-denominated oil price and thus provide a tiny advantage to Canadian oil producers (perhaps manufacturers too, although the Bank has shown no interest in that sector for years). The effect is to raise the producer’s Canadian dollar revenues, but more importantly to discount the cost of wage and service inputs to the industry.

This move was completely unnecessary as the following chart illustrates. Shown is the relationship between the US/Canadian dollar exchange rate and the US dollar-denominated price of oil (WTI) on a monthly basis over the last twenty years. The relationship is remarkable in its consistency and clearly shows that left to its own devices, the market would make the required corrections without central bank interference. It is unclear how much long term damage to the credibility of the Bank of Canada was incurred by this unexpected action.

Interestingly, if you plot the data further back than 20 years you find that the relationship deteriorates, fully suggesting that the Canadian economy has only been a “petro-economy” in the last two decades. Further, at prices over US$110/bbl the linear relationship begins to uncouple which suggests that the amount of additional value that will be credited to the Canadian economy as a result of exceptionally high oil prices is limited.

Note: It makes virtually no difference to the illustration if the plot is in then-current, or in inflation-corrected terms.

image-n8-2

Sources

Once again I reference the tremendous exchange rate resource provided by Professor Werner Antweiler at the University of British Columbia through the website; PACIFIC Exchange Rate Service. (fx.sauder.ubc.ca)

Oil prices were sourced from the website of Sproule & Associates of Calgary, Alberta;
(www.sproule.com)

“Separating the US Dollar from the Price of Oil” in PDF


Copyright © Barchan Advisory Services Ltd. 2016

DON’T MISS AN UPDATE

Subscribe to our mailing list for regular delivery of valuable thought leadership