Europe's Oil Price Spike

In our relentless focus on the excesses of the financial sector, many Americans have forgotten that the severe recession we've just experienced was at least exacerbated, if not partially caused by an oil price shock. Now it might be Europe's turn, as the Euro continues its slide against the US dollar. It's a fairly obvious point that a weakening Euro increases the cost of all commodity imports into the EU's Eurozone, while reducing the effective revenue for any exports made with them. Yet when the import is oil, the effects go beyond international competitiveness.

Oil prices have roughly doubled in dollar terms since their low point in January 2009, but they have gone up by an extra 25% in Euros per barrel over the same interval. The divergence this year is even more striking, as the Euro retreats from its highs of last December. Since January 1, oil is up by nearly 6% in €/bbl but down by nearly 12% in $/bbl, as shown in the chart blow. A further retreat to Euro-dollar parity would see the Eurozone's businesses paying nearly as much for oil in their own currency as they did in September 2008, the last time the US saw prices over $100 per barrel.



The previous strength of the Euro partially insulated the Continent's businesses and consumers from the worst oil-price pain of the first half of 2008. When oil reached its all-time high of $145/bbl in July of that year, it was barely over €90/bbl. Then, as oil prices ebbed, the strong currency/weak oil combo provided a substantial economic stimulus to Europe lasting well into 2009, with oil averaging just €44/bbl last year, compared to $62 here.

The shoe is on the other foot, for now, as Europe enjoys little of the recent weakening of oil prices from levels above $80/bbl, while experiencing a mini-spike since the start of the year. And with various pundits suggesting the Euro still has a ways to fall, Europe could be facing oil prices over €70/bbl, instead of the roughly €60/bbl for which UK Brent Crude effectively trades today. That would compound the fallout from the EU's fiscal crisis and amplify the risk of a double-dip recession, perhaps even globally.

The Weak Dollar

Oil prices have trended upward recently, spurring renewed speculation that only speculation could account for such a shift in the face of relatively weak fundamentals of supply and demand. It's certainly true that inventories of crude oil and refined products remain high, while demand is still well below the levels of just a couple of years ago, and OPEC is sitting on millions of barrels per day of spare capacity that could be deployed quickly if consumption spiked. But although it can't account for 100% of recent price movements, one factor stands out for its contribution to oil's lurch towards $80 per barrel after months of stability around $70: the further weakening of the US dollar relative to the Euro and other strong currencies. The future path of the dollar will be determined by a complex set of factors, including the relationship between US and other nations' interest rates, trade balances, current inflation, and expectations of future inflation. However, it's worth noting that the dollar's recent deterioration is hardly anomalous; it is part of pattern going back decades.

The above chart displays the price of West Texas Intermediate crude oil on the New York Mercantile Exchange since the beginning of August. I've added another line showing the same price in Euros, based on exchange rate data for the period. It's pretty clear that although oil priced in Euros has also been trending upward slightly, perhaps in response to reports that the global demand for other commodities is picking up--indicating that at least some parts of the world are recovering from the Great Recession--the recent upswing in oil prices looks much more muted than when expressed in dollars per barrel. That got me thinking about the long-term exchange rate trends, and where they might take us in the years ahead.

Having lived overseas and traveled extensively, I've been aware of exchange rates for most of my life. That's given me a clear perspective that the dollar isn't just weaker now than it was a few months ago or a couple of years ago, but has been deteriorating more-or-less steadily for a very long time. From my childhood I can recall when a dollar was worth roughly four Deutschmarks, and even my father's salary as a junior Army officer went pretty far on the local economy. As an adult I worked in Germany for a few months in the early 1980s, when a buck still bought more than 2 Marks. With the Deutschmark having been subsumed into the Euro, with its extremely short and volatile history, it's easy to lose sight of the dollar's gradual slippage, which has resulted in an equivalent Deutschmark/Dollar rate today of 1.30:1. Fully appreciating this trend requires examining the longer history of exchange rates between the dollar and more stable currencies such as the Deutschmark and the Swiss Franc, which is now trading at virtual parity with the greenback. It's not a pretty picture, and it has significant implications for a country with such large structural import requirements, not just for energy, but for so many other products.

While I'm not advocating a return to the gold standard or even necessarily dismissing the benefits that a weaker dollar has provided at times, I find the long and bumpy, but nevertheless steadily-downward slope of the dollar's value worrisome. Moreover, it's hard to see what could stem this trend in the near term, with the federal government committed out of necessity to holding short-term interest rates at essentially zero to avoid putting the economy back into a tailspin, while other countries still offer positive interest rates and some have even raised them slightly. Nor do trillion-dollar fiscal deficits seem conducive to a stronger dollar any time soon. What would dollar-denominated oil prices do if the dollar continued to fall past $1.50 per Euro toward the 2:1 level, all other things being equal? $100/bbl probably isn't a bad guess, along with everything else that goes with it.

Rebound or Dead Cat?

US light sweet crude oil closed above $50 per barrel yesterday for the first time since late November. The financial press appears to attribute this mainly to the weakening of the dollar and inflationary expectations triggered by the Federal Reserve's decision to purchase over a trillion dollars of securities, in a bid to reduce longer-term interest rates. Although I don't discount these concerns, a review of oil's fundamentals suggests there are other factors at work, as well. The recovery in oil prices from the mid-$30s has involved more than a one-day rally, nearly a dollar of which had abated as of this morning. It is hardly the kind of rebound we might expect once the recession eases, but if it is sustained it should remind consumers that the current price relief on petroleum products is temporary, while sending producers a positive signal on the need for continued resource development.

Yesterday's weekly statistics from the Energy Information Agency showed that US inventories of crude oil and its two main fuel products, gasoline and distillate (diesel/heating oil), continue to build. But while distillate demand remains very weak, reflecting the decline in goods movement that accompanies a slowdown in economic activity, calculated gasoline demand has returned to within a percent or so of its year-ago level. Gasoline imports are running at a million barrels per day. All of this provides refiners some welcome headroom for their traditional spring-time switch into maximum-gasoline mode, after having optimized on distillate production during the winter. If demand were still as weak as it was a few months ago with gasoline inventories this high, any rally in oil prices would quickly extinguish itself.

Weakness in the dollar relative to other key currencies can also drive crude prices higher. This effect contributed to the extraordinary spike in oil prices from mid-2007 to mid-2008. But many of the factors that fed the resulting "oil-dollar price loop" look too anemic now to create a sustaining pattern of this type, amid the global recession and credit crunch. A slight decline in the Euro or Yen price of oil seems unlikely to stimulate much demand. Unless the dollar continued to weaken progressively, turning its recent 8% slide against the Euro into something more serious, it's hard to see this sustaining higher oil prices against the fundamentals.

The notion of oil as an inflation hedge is another matter. Traders aren't the only ones who get the jitters at the thought of the US government printing money to buy its way out of our current problems. However, inflation worries seem premature when deflation remains a serious risk. The latest report on seasonally-adjusted US consumer prices showed "core inflation"--excluding food and energy--rising at a sub-2% clip, while the three-month and twelve-month averages for the prices of all items are still in negative territory. The whole point of the stimulus bill was to soak up the enormous slack capacity in the economy, and until that begins to bite, the idea of too much money chasing too few goods seems a remote prospect. Nor did oil work out very well as an inflation hedge last summer, when the CPI was growing at more than 5% per year.

And that brings me back to oil's fundamentals. The fact that the market didn't swoon when OPEC met and decided to defer further cuts suggests that they have reduced output sufficiently--and are living up to their lower quotas well enough--to create an environment in which events such as the Fed's move can be seen as bullish. It wasn't long ago that it seemed nothing could drive up oil prices for more than a day or two. At the same time, oil's recent moves haven't flattened out the remarkable degree of "contango" that I observed in December. Oil futures for delivery twelve months from now are $10/bbl higher than the front-month price. That suggests the market is still weighed down by high inventories and tight credit, impeding the obvious arbitrage opportunity such wide spreads create. A more dramatic rebound in oil prices must still wait for the global economy to begin to turn around and draw down that overhang. In the meantime, though, the 50% appreciation of oil from its low on February 12th looks like rather more than the proverbial bounce of a dead cat.

Another Tumultuous Year?

Whether or not next week's inauguration of the 44th President of the United States marks the true start to the 21st century, as a Washington Post columnist recently suggested, 2009 could herald momentous changes in long-term energy trends. While a return to the extraordinarily high oil prices we experienced last summer looks improbable, we could yet see a significant price spike as a result of geopolitical events--or a further slide towards $30 per barrel. Developers of alternative energy technologies and projects will be watching Washington intently, in hopes that the expected stimulus bill or separate energy legislation will boost their fortunes and unlock access to persistently tight credit. And against that backdrop, the behavior of consumers in a new economic environment bears watching, as the ultimate source of energy demand.

In no particular order, here's my list of energy trends and events to watch as the year gets underway:

• Oil prices are being squeezed between the weight of accumulating inventories, especially at the Cushing, OK storage that comprises the New York Mercantile Exchange's main delivery point for West Texas Intermediate crude oil, and the anticipation that a combination of OPEC discipline and resurgent demand will tighten markets appreciably later in the year. The resulting contango remains very wide. The prompt contract, for delivery in February, has fallen below $40 per barrel, while oil for delivery in July sells for well over $50/bbl, with next year's crude going for more than $60.
• As I noted on Friday, the gap between oil and natural gas has closed, even as gas has fallen below $5.50 per million BTUs, a level that is providing an energy-price stimulus for industrial and utility customers similar to the one that sub-$2 gasoline gives consumers. Gas is in contango, as well, though hardly as steep as oil. How long will the present US gas supply bubble persist, given the rapid decline rates of many gas wells and the weak finances of many of the big producers?
• The influence of government over energy looks certain to expand this year. Will the stimulus bill satisfy the wish list of alternative energy and environmental advocates, including assistance for struggling ethanol producers, cash subsidies and loan guarantees for wind and solar firms, and big investments in infrastructure, including new long-distance power transmission and a down payment on the "smart grid" of the future?
• An article in this morning's Wall Street Journal raised the prospect of a new wave of energy industry consolidation, similar to the one that created the "Super-Majors" (Exxon-Mobil, BP-Amoco-ARCO, Chevron-Texaco, Elf-Fina-Total) starting a decade ago. The industrial logic is probably there, though any merger would play out in a political context that seems much less likely to be receptive to such combinations, even if the publicly-traded oil companies do account for less than 10% of global oil reserves and less than 20% of production.
• If the financial crisis has pushed geopolitical risk into the background, the conflict in Gaza and the revelation over the weekend that Israel had asked for US assistance in an attack on Iran's nuclear complex should remind us that it hasn't vanished entirely. Although the oil market is in a much better position to forgo Iran's oil exports than it would have been for the last several years, taking 2 million barrels per day off the market--a likely response to any attack on Iran--could still be good for a quick pop of $15-20/bbl, or an extra $0.40 or so per gallon at the pump.
• Last year's weakness in the US dollar contributed to the summer's high oil prices, and the late-year dollar rally helped to unwind the residue of that spike. As the US deficit expands past $1 Trillion next year and into 2010, between fiscal stimulus and falling tax revenues, could the dollar begin falling again, and if so, what would that mean for energy prices? Economists tend to view these deficits as a manageable fraction of GDP. However, in absolute terms they are enormous, and they will compete with deficit spending all over the globe, taking us into uncharted territory.
• Finally, we can't forget about consumers. If the sharp drop in demand--around 6% year-on-year--was the pin that popped the oil-price balloon, will low gas prices begin to revive it? But while today's average pump price for regular gasoline of $1.68/gal. is a whopping $1.42/gal. less than last January and $0.62 lower than the same week in 2007, it surely doesn't look quite so cheap as a fraction of average purchasing power, between declining home values that have dried up the home equity loans with which many consumers were supplementing their income, and rising unemployment. It will take some time to see whether the weak economy and vivid memories of $4+ gasoline have altered consumption patterns permanently, or just temporarily. That will have important implications for environmental policy, too.

It's going to be interesting, for good or ill, and I look forward to continue sharing my perspective on energy and related environmental matters with you, as Energy Outlook begins its sixth year.

Weak Signals

Today’s posting will be brief, since I’m traveling. An item in this morning’s Wall St. Journal caught my eye. It interpreted some recent oil-related options trading as an indication that some market participants expect a correction in oil prices. While I share the view that oil at $118 per barrel has inflated beyond any realistic interpretation of the supply and demand fundamentals, even with the prospect of a further deterioration of the dollar exchange rate, I wouldn’t make too much of this news. Oil futures have run up by more than $10 in the last two weeks, and it wouldn’t require deep pessimism for traders to want to buy a little insurance. They could pay for it with the profits from just the last day or two.

At the same time, while a correction seems long overdue, I’m concerned that oil has reached its current heights without any major supply crisis, driving the average US retail gasoline price above $3.50/gallon without any serious refining or product distribution problem. An event on either front could send oil prices or refining margins to levels that would quickly translate into another 20-30 cents per gallon at the pump, pushing large parts of the county over the $4.00 mark, which is already appearing at higher-priced retailers in California.

As consumers contemplate that possibility, we should remember that we have more influence over prices than we think. A 0.5 mile-per-gallon improvement in fuel economy from avoiding jackrabbit starts and coasting into stops--rather than accelerating until the last moment—would aggregate to a 6 million barrel per month reduction in demand and ease the pressure on prices, while filling up at ½ instead of ¼ would deplete US gasoline inventories by 10 million barrels, or about 5%. That could make $4 gas a self-fulfilling prophesy.

Blaming the Buck

The lead editorial in today's Wall Street Journal (subscription required) attributes much of the recent increase in oil prices to the weakness of the dollar, and to the monetary policies of the Federal Reserve. As evidence for this argument, they present a chart of the relative value of oil in dollars, Euros, and gold for the last eight years. Although the editors make the obligatory nod to the growth of demand and problems of supply, they contribute to the general sense that our energy problems can be blamed on some unaccountable party: OPEC, oil companies, or now the Fed. This absolves us from the contribution of our personal consumption habits, while failing to differentiate cause from effect.

The Journal is hardly the first to notice the inconvenient relationship between a depreciating dollar and higher commodity prices. Among others, I suggested a few months ago that this might constitute a worrying feedback loop, with higher oil prices further weakening the dollar, a weaker dollar driving up oil prices, and so on. A closer look at the relative value chart in the editorial provides a sense of the relative importance of this factor among the many affecting global energy prices. Using gold as the measure of price stability ignores its status as an important industrial commodity, participating in the same global commodity trends affecting steel, copper, grains, and other goods affected by the sustained rapid growth of China, India and other developing countries. If instead we choose the Euro as our proxy for stable value, we see that the real price of oil has at least doubled since 2000, reflecting the 11% increase in global oil demand that consumed the surplus production capacity that had been left after the collapse of oil prices in the late 1990s, along with virtually every barrel of new capacity put into service since then. A weak dollar exaggerates but did not create this trend.

The other implication raised by the editorial is that Federal Reserve policy might offer a mechanism for pushing oil prices back to more comfortable levels. There's something to this, though the cure might be worse than the disease. A couple of interest rate hikes could pull the dollar out of its current slump, and lower oil prices would likely follow, not just because the dollar would be more valuable, but because the US economy would be pushed into recession, thereby reducing estimates of future US demand and easing speculative pressure on oil. That's hardly an appealing scenario, however.

What we're left with, then, is an interesting observation about another consequence of US policies that have generally promoted consumption but not production--and not just for oil--but one that offers no real help in addressing the problem. That lies with the fundamentals of supply and demand, more sensible energy policies, and the creation of a public consciousness that connects the results of policy and personal choices with the price at the pump--whether denominated in dollars, Euros, or ounces of gold.

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.