For a couple of years before the current spectacular slide in oil prices began in mid-2014, we had been warning that the oil market was in a bubble stage and that the bubble was at some point going to burst. As economist Herbert Stein famously remarked, “Things that can’t go on forever, usually don’t.” Not only did oil prices come down, but long-term prospects for the black gold are black rather than golden. Nevertheless, over the medium term, we might see the continuation of the recent upswing in oil prices and even a period of oil price strength.
Technology, which increasingly controls supply and demand for oil, will continue to move forward by leaps and bounds and weigh heavily on oil prices. But oil prices are not closely correlated with supply and demand. Rather, oil prices are set by the futures markets, which are deep and highly liquid financial markets. Since oil is traded in dollars, the commodity’s near- and medium-term price movements are closely correlated with the value of the greenback in currency markets.
The dollar, in turn, is highly sensitive to political considerations. Following this year’s presidential election, the United States appears to be entering a period of political instability at home and considerable weakness abroad. This will keep the dollar low for the next few years and will push oil prices higher — possibly even to fresh records.
Higher oil prices will doubtless provide respite to many oil producing countries, which have been facing severe economic woes and have even been pushed to the brink of bankruptcy. However, the rally will only delay the inevitable. Actually, it ensures things ultimately will be even worse for petroleum producers: higher oil prices will give another boost to the development of new technologies and seal the fate of those oil producers that fail to diversify their economies.
Crude prices are up by more than 50% from their January lows. Economists tend to focus on issues of supply and demand as they analyze market behavior, but recent news on that front has been ambiguous, to say the least. As oil prices move higher, analysts pay a lot more attention to news items that are positive for oil, such as a jump in oil imports from China, where the government is building up its strategic oil reserves, and lower production in the U.S., Canada and elsewhere.
However, there are just as many factors pointing in the opposite direction — to the continued and even worsening oil glut. In April, OPEC failed to agree on production cuts; on the contrary, many members of the formerly all-powerful cartel are likely to boost production in the hope of recapturing their lost market shares. Countries like Iraq, Russia and Iran (the latter now getting ready to boost oil production and exports in the aftermath of its nuclear deal) are in dire need for cash and have no other way of getting their hands on it.
On the demand side, the macroeconomic news is not especially encouraging for oil producers, either. The International Monetary Fund recently joined other international agencies in lowering its forecast for worldwide economic growth. Western Europe and Japan are mired in deflation and won’t see much growth any time soon. Brazil is going through an economic slump and has been hit by political turmoil. The U.S. economy is slowing. Nor is China the economic locomotive it once was; on the contrary, it is showing every sign of becoming the sick man of the global economy.
Whatever growth there has been comes from other parts of Asia. It won’t be enough to power global oil demand — especially since many governments in the region have taken advantage of lower crude prices to reduce or eliminate costly domestic fuel subsidies. Consumers have not seen much of the effect of lower oil prices and therefore oil consumption in those countries is unlikely to take off.
In fact, the recent global boom in car sales can prove to be a net negative for long-term demand for oil. Drivers have been replacing their antiquated gas-guzzlers with modern, highly fuel-efficient vehicles.
While supply and demand do impact trends in the oil market over the longer term, near-term oil prices are set by financial factors. Futures contracts for oil are first and foremost financial instruments. The value of futures contracts traded in London and New York far exceeds the amount of physical commodity produced around the world. So it is demand for such contracts that is responsible for the price movements of the physical commodity.
Oil is traded in dollars, and oil prices and the dollar exchange rate are closely correlated — more closely, in fact, than the volume of oil that is being pumped out of the ground or used by the chemical industry, power generation or drivers. A stronger dollar has traditionally meant lower oil prices, and vice versa.
This has been seen throughout recent history, as the weakness of the dollar in the 1970s was accompanied by a jump in oil prices. The dollar was strong during the 1980s, and oil prices correspondingly dropped, reaching their nadir in the late 1990s when the greenback traded well above parity versus the euro. A period of dollar weakness then followed in the early years of the century — when the WSJ Dollar Index lost 35% of its value between 2001 and 2008. Accordingly, oil prices shot up to new records.
If anything, the correlation has become stronger with the growth of financial markets since 1980 and the dominance of futures markets in setting the price of oil.
Moreover, since the global financial crisis of 2008, the main factor moving financial markets has been the creation of dollar liquidity by the U.S. Federal Reserve. The Fed’s quantitative easing programs infused more than $3 trillion into the global financial system over the ensuing six years. The purpose was to float financial institutions and to encourage them to lend to businesses and consumers. However, the bulk of that liquidity flowed into other financial markets — notably into oil futures, which represent a readily available, very deep and liquid store of value for dollar-denominated liquidity.
Between early 2011 and mid-2014 oil prices averaged well above $100 per barrel at a time when global economic growth was sluggish and, moreover, new supply from fracking and other sources was hitting the market — matters about which oil traders were perfectly aware.
The fact that oil prices tumbled so quickly and definitively has been the best indication that the oil market had been in a bubble stage.
The exact moment when the oil bubble popped was also significant. The Fed started tapering off its quantitative easing program in 2013 and stopped buying bonds completely in October 2014. You would expect oil prices to rise — since the end of quantitative easing signaled that the U.S. economy was finally finding its legs. However, oil prices actually dropped precipitously in mid-2014.
On the other hand, as oil prices tumbled, the trade-weighted exchange rate of the U.S. dollar began to rise. In other words, the dollar strengthened against most other currencies. It gained, on average, a quarter of its value against other currencies by end-2015. The WSJ Dollar Index was back to where it had been in 2002 — and oil prices were at about the same level back then, as well. The peak for the dollar — and the nadir for the oil price — came just after the Fed raised its interest rates for the first time in nearly a decade in December.
Interest rate movements and the printing of paper dollars are not the only forces that determine the value of the dollar. The dollar is highly sensitive to political considerations. Once again, history provides an important guide to this relationship. In the 1970s, the U.S. was grappling with the post-Vietnam syndrome, social turmoil at home and major reverses in foreign policy. Communism was advancing in Asia, Africa and Latin America, as Washington appeared to be losing the Cold War on all fronts. The dollar was plumbing the lower depths and the trend was reversed only when the Reagan Administration reasserted America’s global position. Similarly, 9/11 and wars in Iraq and Afghanistan led to the decline of the greenback.
While Wall Street has remained remarkably oblivious to the presidential campaign, foreign exchange markets have reacted to it nervously. The greenback softened and alternative safe havens, the Swiss franc and the yen, moved higher.
Donald Trump, the presumptive Republican nominee, represents a serious threat to the post-World War II global political order and America’s dominance. If implemented, his policies will alienate America’s neighbors, allies and trading partners, promote trade wars and destroy the framework of international rules and regulations. This could exacerbate regional conflicts and unleash an international arms race.
While Bernie Sanders has little hope of winning the Democratic nomination, he has already pushed the Democratic platform toward protectionism. More to the point, neither his nor Trump voters will go away even if their candidates lose. President Hillary Clinton will face obstruction and severe gridlock. The election has revealed the extent to which Americans have grown dissatisfied with their economic system and how much they blame America’s international role for their current plight and diminished economic expectations.
The result will be renewed domestic turmoil and reverses abroad, with Muslim fundamentalists, Russia and China gaining ground for their agendas. This will also undermine the dollar.
On the macroeconomic level, the long-term supply-demand relationship in the oil market points to continued glut and enduring price weakness. The oil market, which for decades was dominated by oil exporting countries, is now governed by technology — new, more efficient production and exploration methods allowing producers to tap deposits such as shale and the deep sea; plus, energy efficiency and alternative and renewable energy. But the weak dollar will negate these trends, at least for a while, leading to higher oil prices.