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Weak dollar, cheap oil
The prices of crude oil and liquid fuels are quoted in US dollars, with transactions also made in that currency. However, 90% of the supply of these commodities and 80% of the demand come from outside the US, being settled in other currencies. The oil prices and American currency rates have usually been negatively correlated: an appreciation of the US dollar typically accompanied by a fall in oil prices, and vice versa. However, there are many indications that the trend of a weakening dollar will continue into the next year, accompanied by a downward trend in oil prices.
I discussed the negative correlation mechanism three years ago, explaining reasons for its temporary disruption, linked to a structural strengthening of the dollar. Its mainspring is the response of oil supply to a change in its price, which for 90% of the supply is in a currency other than the US dollar. As the dollar strengthens, other currencies, including those of oil producing countries, follow the opposite trend. One effect of the dollar strengthening felt by oil exporters is, therefore, an increase in the price of oil in the local currency and in revenues from its sale. This could prompt a spike in crude output, but few of them can achieve it at short notice. These are primarily countries with large spare production capacities which can be immediately brought online – Saudi Arabia, Kuwait and Qatar, that is the OPEC cartel. Outside of OPEC, an increase in output in not readily achievable: it takes from three to six months in the case of shale deposits, from three to five years in the case of conventional deposits, and over eight years in the case of deepwater offshore deposits. An increase in output by the OPEC cartel leads to a reduction in the US dollar price of oil. It is worth noting that American companies producing oil from shale watch oil prices in the US dollar, not reacting to the exchange rate, but only to supply changes on the physical oil market.
As the dollar weakens, the currencies of non-US exporters become stronger, oil in these currencies becomes cheaper and export revenues decline. A lower price of oil is generally a signal to cut back supply, although not everyone is interested. Non-OPEC producers strive to maximise output from producing fields, guided by the optimal production level rather than exchange rate fluctuations. No all OPEC countries are in the same position, either. For all of them, oil exports are the main source of budget revenues. A production cutback by one country, without a united front by all cartel members, is not a viable solution for many, because it would reduce proceeds without driving up the price of oil. There is also fear that a neighbour might fill the supply gap. Therefore, OPEC’s production cutbacks require a cartel-wide deal, and the measure of their effectiveness is an increase in US dollar oil prices.
At present, OPEC countries are effectively implementing a deal to cut production, aiming to boost oil prices and export revenues. However, the prospect of a long-term weakening of the US dollar makes this goal look like a tall order. US dollar oil prices may have risen, but a rise in local prices is significantly less pronounced, undercutting export receipts, which in turn increases the pressure to maintain output quotas for a longer time, or even lower them further. On the other hand, deeper output curbs put stronger pressure on an increase in US dollar prices and US supply of oil. This is because rising oil prices in the US currency are effectively driving up production volumes, which in turn work to suppress prices. Because the US dollar rate is not a factor taken into account in decisions regarding US extraction levels, the correlation mechanism between the price of crude oil with the US dollar rate has significantly weakened.
In my December post, I was trying to demonstrate that oil supply should suffice to meet the fast growing demand in 2018 and 2019 at an average annual price below USD 60 per barrel. At the end of January, I argued that the rise in prices close to USD 70 was due to temporary factors, fuelled by speculative transactions on paper markets. I concluded that the attractiveness of backwardation for financial investors may continue to support the upward trend in oil prices for some time. However, if no new oil supply cuts are imposed in the coming months, crude prices should fall in the next quarter or two. A few days after this publication, a correction swept across the financial and commodity markets, bringing the price of oil to around USD 60. The Americans passed the price test, reduced production costs by half, and shifted the commercial viability range from USD 60-80 to USD 30-40 per barrel of WTI oil. In consequence, at prices above USD 60 per barrel they are having a golden harvest. In November last year, the volume of US produced oil exceeded 10 mbd, and is set grow by a further 1.3 mbd in 2018. That’s as much as was produced in 2014 at the price of WTI oil in the region of USD 90 per barrel. Considering a faster growth of supply in Canada and Brazil and the maintenance of OPEC output at current levels, supply surpluses should be seen from mid-2018 and continue into 2019, despite a strong rise in demand, forecast at 1.9 mbd in 2018 and 1.6 mbd in 2019 (to compare, in 2015-2019, after taking into account the 2015-2017 data, demand will grow from by an average of 1.7 mbd year on year, the same as in 2003-2007). Absent new geopolitical factors or other acts of god limiting supply, the price of Brent crude oil in 2018 will probably approach USD 60 per barrel, and in 2019 may hover slightly below this level.
Let us now return to the US dollar and causes of its weakness. The issue was studied by economists from the Bank of International Settlements in Basel, who presented their findings in a recently published article with the meaningful title: “The dollar exchange rate as a global risk factor: evidence from investment” (BIS Working Papers No. 695, January 2018). What conclusions did they reach? In a nutshell – the reason behind a weakening dollar is synchronous economic growth outside the US. Businesses, mainly from emerging economies, are ramping up investment, financing their investment expenditures with US dollar-denominated loans from domestic banks or with funds raised from sale of US bonds (a reserve currency, the most liquid market, a relatively low cost compared with local currency loans). Exchange of US dollars into local currencies weakens the former (due to an increase of dollar supply in circulation), while strengthening the latter (as the local currencies are more in demand). This stream of dollar supply outside the US definitely outweighs demand for US bonds and securities. This situation will last for as long as the pace of global economic growth is accelerating. According to forecasts by major international banks, it will last for at least two years, with the USD/EUR exchange rate reaching 1.30 at the end of 2018 and 1.40 a year later. This is hardly surprising if we think of the average USD/EUR rate of 1.37 in 1999-2007, when the global economy was rapidly expanding.
Therefore, if nothing unexpected happens, then for the next two years we can see a combination of a weakening dollar and falling oil prices. As these are the main factors affecting trends on the national fuel markets, this spells good news for motorists. Will this scenario materialise? We’ll see.
Adam B. Czyżewski, Ph.D., has been the Chief Economist at PKN ORLEN since 2007. He specialises in the changes of the global energy sector that are driven by economic policies and revolutionary innovations.