Why Oil Prices Are Heading Higher

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.

Unexpected Rally

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.

Almighty Dollar?

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.