Friday, September 21, 2007

The Oil-Dollar Price Loop

Positive-feedback loops have become a familiar concept, thanks in part to the science of climate change. A warmer atmosphere melts icecaps and glaciers, which in turn reflect less sunlight back into space, causing the atmosphere to warm further, and repeat. Such relationships exist in many systems, and an article in yesterday's Wall Street Journal started me wondering if we are experiencing such a loop involving oil prices and the value of the US dollar. If so, the practical limit on the dollar price of oil could be much higher than we might otherwise expect.

Over the last several years I've discussed many reasons why oil prices have increased so dramatically, compared to their level prior to 2004. It's a long list, including the shift in power from commercial oil companies to national oil companies, and from non-OPEC producers to OPEC, geopolitical tensions, the growth of Asia, inventory, speculation, and even the lagged impact of the late 1990s oil price collapse. At first glance, though, because oil is normally traded in dollars, the value of the dollar itself might not seem to belong on that list. In a world awash in oil, it probably wouldn't. However, a dollar that is shrinking relative to other major currencies has at least two effects on oil, in a market that is already tight.

First, it reduces the income of producers, who sell in dollars. That leaves them less cash to reinvest in new production. At the same time, it makes oil cheaper in the currencies of other consuming countries, relieving the pressure on them to consume less and helping them to out-compete us for the world's available oil exports. Each of these factors alone would tend to drive up the dollar price of oil; with the oil market being driven by supply constraints (OPEC quotas) and rising demand, both effects operate. More importantly, they appear to work in a self-reinforcing fashion, linked back through their impact on the dollar.

So imagine a closed loop, and follow it around a cycle:
  1. The value of the dollar drops.

  2. Non-US demand rises and supply tightens, as discussed above.

  3. The dollar price of oil increases.

  4. The US trade deficit worsens, and foreigners hold more dollars than they need to buy US goods or assets.

  5. Return to step 1.
Events such as this week's interest rate cut by the Fed also feed this cycle, by weakening the dollar while propping up our economy and thus our oil demand. Of course, none of this happens instantaneously or in isolation. Many other things influence oil prices, exchange rates, and the other components of this highly-simplified feedback loop.

There's also a natural point at which these loops start to de-couple, and we could be nearing it. The growth of China and other large developing countries may be driving global oil demand, but we still import a quarter of all the oil that's exported around the world. Once the price gets high enough to dampen US oil demand and imports--or when the underlying factors weakening the dollar have the same effect--then this loop starts to run down. But at what oil price does that occur? I expected it long before we reached $80 per barrel, and there are signs that demand is slowing. Total petroleum products supplied in the US, one measure of demand, was down by about 0.5% for the last six weeks, compared to the same period last year, and total crude oil and petroleum product imports were down by a larger fraction. Time will tell whether this is a trend, or a random fluctuation. Meanwhile, I'll be watching exchange rates more closely than I used to.

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