Adam Czyzewski

Crude oil and the US dollar are interconnected on many levels. Oil is one of the world’s most important commodities, while the dollar is the most powerful reserve currency, held by central banks as part of their foreign exchange reserves. Changes in the price of oil and USD exchange rates have a strong impact on the state and prospects of the global economy while being dependent on the economy’s condition. Although transactions on the global market for crude oil and petroleum products are executed in US dollars, 90% of the global supply and 80% of the global demand for the commodities originates from outside the US and is denominated in other currencies. In consequence, changes in USD exchange rates are reflected in crude oil prices. Historically, these were negatively correlated: the appreciation of the US dollar typically encouraged lower crude prices, while the depreciation of the currency produced an opposite reaction. Interestingly, both the price of oil and USD exchange rates are now changing, for different reasons, to reach a new state of equilibrium. The US dollar has been growing rapidly in value since last summer, and this appreciation has solid structural foundations in the improved condition of the American economy. The process has been driven by the strong growth in oil production in the US and Canada seen over the recent years. It has been the main reason behind the oil price slump which began last summer. For several months, the processes reinforced each other and eventually the appreciation of the US dollar accelerated the decline in oil prices. In late January and early February, the negative correlation that used to obtain between the price of oil and USD exchange rates changed: the price of crude began to rise despite the continuing appreciation of the US dollar. The reasons behind this situation deserve a closer look, as the appreciation of the US dollar which is not accompanied by falling oil prices slows down the adjustment process on the crude oil market by weakening the price signals originating from the market.


When the dollar appreciates, the price of oil and petroleum products denominated in importers’ currencies goes up. Rising prices depress demand and create pressure to reduce oil prices in the US dollar. The historical mechanism correlating the price of crude oil with USD exchange rates created a situation in which oil producing countries (OPEC, Russia, Brazil and Mexico) accepted lower USD-denominated market prices if they received appropriate compensation in the form of higher revenues in their local currencies. In effect, the appreciation of the US dollar did not impede demand for oil. However, the decision to accept lower market prices had to be approved by OPEC, which could manipulate prices by adjusting production. When the price of crude oil fell too low, the cartel used this ability to communicate to the markets the price level it was prepared to defend. Anchored price expectations facilitated taking positions on financial oil markets and had a stabilising effect.


On November 25th 2014, the mechanism shaping crude oil prices changed. Acting to defend its market share, OPEC resolved to shift its position to that of a price taker, taking the anchor for crude oil prices away from the markets, which are now making efforts to establish a new equilibrium price in its place. For now, we only know that the price is situated significantly below the abandoned anchor and depends on the cost of producing the marginal barrel (the most expensive barrel for which there is demand). According to the previous mechanism, the price − OPEC’s anchor − was the axis around which the market revolved. Now only the market is left. It will find the equilibrium price eventually, but it may take some time.


Adjustments have to take place on the physical market, which is currently experiencing a surplus of production potential due to the increased shale oil production in the US and Canada. As the shale oil production technology cuts the investment cycle from several years down to three months, the adjustment process originates in this production segment. The wide spectrum of production costs seems to suggest that the marginal barrel may be found outside of the US, and the price signals from the oil market provide the information necessary to locate it. Given the appreciation of the US dollar against local currencies, the price signals reach non-US producers markedly weakened. Russia is an extreme example. Pressured by international sanctions, the ruble has depreciated against the US dollar to such an extent that it offset the 50% decline in USD-denominated URALS oil prices observed on the domestic market since June 2014. In February 2015, the average price of URALS in rubles per barrel was only 4% lower than in June 2014.


Financial oil markets and their connections to the money market play an important role in the mechanism which determines crude oil prices. Oil futures and options, used to hedge financial transactions on physical markets, are traded on financial markets, whose scale has been growing steadily. Currently, the value of purchased hedging instruments tied to WTI and Brent crudes, denominated in the US dollar, is 10 to 15 times that of the hedged transactions. According to IHS estimates, the total number of oil barrels under financial contracts on both the American and European markets in early March alone would be enough to meet two months worth of global oil demand this year. And it should be remembered that the actual oil hedged on financial markets represents only a small portion of the global production.


The expansion of financial oil markets is associated with the growing share of positions which are purely speculative rather than connected with transactions on the physical market. Such positions are taken in respect of anticipated price shifts and their only purpose is to secure financial gains. Players on the money market react sharply to any new information, share a herd mentality and tend to overreact. Characteristically, trends on the money market are derived from short-term processes, which are highly susceptible to change. As regards the crude oil market, now deprived of the price anchor, we can expect prices to become more prone to change and to fluctuate ever more widely. Since price signals coming from the oil market are not only uncertain, but also weakened as a result of the appreciating US dollar, it is almost certain that the necessary adjustments on the physical oil market will require a longer time span.

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