Viva Chile, Viva Oil - By Markaz Oil & Gas Department


Last week was marked by two prominent events, one for humanity and the other for investors across the world.

First, an inspiring culmination of the final leg of Chilean miners rescue operation, which was watched live by billions across the world, in awe and with bated breath. One after another, the 33 miners came out of the “hole”. The excitement and relief that was felt across the world, was summarized well by Peggy Noonan in her Wall Street Journal article, “Chile! Viva Chile! They left no man behind.”

The second event, which the general public might not have given as much attention to, has already started impacting investors in the financial markets across the world. It was US Federal Reserve’s Chairman, Ben Bernanke’s speech on October 15. “There would appear - all else being equal - to be a case for further action,” Bernanke said., This echoed similar comments made during his speech on August 27, in Jackson Hole, Wyoming; “Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus” because inflation is still low.

So, two contrasting stories, the first celebrating coming out of a hole, and the second one of pushing the dollar deeper into the hole!

During the 7 weeks period between Bernanke’s two speeches, the spot dollar index – which measures the performance of the US dollar against a basket of currencies: EUR, JPY, GBP, CAD, CHF and SE – declined by more than 7%! That is a fairly large movement in currency markets over such a short period.

The GCC, the Dollar and Crude Oil

It is a common knowledge that GCC economies are primarily dependent on oil and particularly oil export revenues. Furthermore, any impact on the dollar is likely to cause turbulence in oil markets and consequently in GCC economies. This is a well covered and researched relationship (the dollar and Oil) in academe and political circles. It is a complex relationship, and as usually happens in such matters, there are no clear cut answers.

The million dollar question, or should we say the million barrel question, is which one is a better measure of value of the other the dollar or oil? A million dollars a few years ago isn’t the same today, and given the pace of quantitative easing post the financial crisis, a million dollars today may not be worth the same amount of goods and services, say a decade from now. In contrast, a barrel of oil is a barrel of oil; it is the same bundle of energy (assuming the same specifications) yesterday, today and tomorrow!

Critics even say that the global dominance of the US dollar over the last 6-7 decades, owes a significant contribution from the oil industry. Major exporting countries of oil are concentrated, with OPEC being a major bloc, and all trades are denominated in oil. The USA is the largest consumer nation, and it makes sense for them to see that they can pay for their oil in their own currency. Other consuming countries (say Japan, China, Euro zone, India, etc.) need to “buy” dollars for the payment of their “oil imports”. To do that, they export their other goods in dollars to gain hold of dollars in order to import oil. This increases demand for the USD and increases its value. The USA is happy, as it can continue printing more and more, and consume hard resources like oil and goods and services produced by other countries, and pay a “hard” currency.

The above paragraph seems straight out of some conspiracy theory book or novel, but this may not be too far from truth. On 15 August 1971, the USA officially reneged on its commitment to repay in gold for the dollar, and it is not a coincidence that OPEC countries in their January 1972 meeting were demanding a price increase of 8.6%; which was equal to the decline of value of the dollar in gold terms. It is important to note that the impact of the dollar devaluation on those oil producing countries, which import significantly from the USA, and other US dollar pegged currency nations, is not equally adverse compared to those producers who import from non-dollar economies (e.g. Japan, Euro zone) for meeting their needs.

However, oil pricing has changed a lot from the era of posted prices, to reference prices and became a real time event with the advent of futures trading of paper barrels. Any event impacting the demand, supply, inventory positions, currency movement, liquidity and speculative pressures, etc., quickly moves the prices; sometimes to extremes on either side.

Another Observation

A “Weaker dollar lifts oil” scream headlines in media and academic research efforts rush to find some sort of correlation and causal effects. A study by Sadek Melham and Michel Teraza in 2007 claimed that that in the long term, “1% depreciation in US dollar (with respect to Euro) coincides with 1.95% increase in oil prices”.

However, such themes only appear when the oil prices are trending upwards. The reverse is not true, that is one will hardly notice similar headlines, except maybe to explain minor daily price movements or noise, when the dollar strengthened, but oil prices did not move down by a similar magnitude as that of the uptrend. For example, the US$ index rallied approximately 15% from the beginning of this year 2010 to the first week of June 2010, as investors piled into the “safe haven” of US treasuries when the Greek sovereign debt crisis was pounding the Euro and concerns on other countries were making investors nervous. During the same period, oil prices declined by only 5% as measured by changes in the OPEC basket price.

On the other hand, during the seven week period between Ben Bernanke’s speeches, from August 27, 2010 when the dollar declined by 7%, OPEC’s basket oil price rose more than 12% ( from ~ 72 to $81/bbl). If we consider a longer, say a 5 year horizon, the dollar index has declined by 13.9% from October 2005 to today’s level, but meanwhile oil prices are up more than 50% during the same period.

Concluding remarks

Without going into debates on whether the dollar drives the oil price or vice versa, and without breaking our heads on analyzing the long list of assumptions and caveats, which each academic exercise on the subject entails, with simple common sense one can observe that the currency factor alone cannot explain increasing or falling oil prices. Otherwise in the long term it would have increased or decreased by a similar percentage movement.

Using the same phrase used in almost all economic studies and speeches of economists, including Fed chairman, “ceteris paribus” meaning “all else being equal”, one can also say that “Over a short time period at least, oil prices are likely to move negatively to USD movement, ceteris paribus”. In life, and in financial markets, however, all else are rarely equal! In the long run, oil prices are determined by myriad factors and it is perhaps extremely difficult, if not impossible, to forecast oil prices with reasonable accuracy. It is perhaps even more difficult, to try forecasting price movement only by studying currency movement.

Nevertheless, as of today, few things are becoming clearer and there are indications that (a) the Fed’s continued policy of stimulating the US economy through further quantitative easing are likely to keep USD on a decline curve, except some occasional technical bounces, for an extended period of time ; (b) Currency wars are intensifying with other countries facing a devaluation of their reserves and decline in their export competitiveness due to appreciation pressure on their own currencies ; (c) Oil, like other hard commodities, is likely to benefit from higher demand due to enhanced economic recovery, supply limitations and some support due to currency movements.

Therefore, while we do not find ourselves in a position to predict oil prices, or develop a precise estimate for US dollar decline or its exact impact on oil prices and developing some sort of exotic arbitrage strategy to benefit from this, we are nevertheless, reasonably confident, that over a medium to long term horizon, investors in the oil levered assets or related services segments, would not only benefit in dollar terms (or in terms of dollar pegged currencies) alone, but will also be able to weather the financial storms and come out as winners in real terms, too.

It is, therefore, we ask you to join us in cheering today:

“Viva Chile! Viva Oil!”
About Kuwait Financial Centre “Markaz”

Kuwait Financial Centre S.A.K. 'Markaz', with total assets under management of over KD928 million (USD 3.19 billion) as of June 30, 2010, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997.