Musings: China, the U.S. Dollar and Crude Oil Prices

Crude oil futures through last Friday had climbed 17% since the end of 2008. From the 2008 low on December 23 of $30.28 a barrel, crude oil futures are up an amazing 73%. In spite of that dramatic rise, it was less than 120 days ago that crude oil was trading in the mid $50 range. That speaks to the speed of the collapse of global oil prices and how explosive the recent recovery in prices has been. The improved oil price has come in the face of weak oil demand worldwide and growing oil and refined product inventories. If global economic activity has, to quote legendary investor Warren Buffett, "fallen off the cliff," one has to wonder why oil prices have climbed from the basement.

A primary reason for the recovery in oil prices has been a general recovery in commodity prices. According to an article in The Wall Street Journal, investor sentiment has turned positive triggered by the Federal Reserve's decision to ease credit with its massive $1.125 trillion liquidity infusion. That decision sparked a rally in almost all commodities - both hard and soft. The rally was further supported by several positive economic data points - U.S. gasoline consumption rising, electricity use in China increasing 6% in February, a surprising increase in housing sales and durable orders. Whether these data points will prove turning points in sustainable U.S. and/or global economic activity remains to be seen, but market optimists are viewing them as green shoots in late winter snows.

Another consideration is that the value of the U.S. dollar is falling after an extended period of strength driven by a flight to quality or security as investors have perceived that the United States was stronger and would solve its financial and economic challenges sooner than other countries. When we examine the trend in the value of the U.S. dollar compared to crude oil prices, it is clear that there largely has been an inverse relationship. As the value of the U.S. dollar was above 100, oil prices were weak (in the $20s) during most of 2000-2002. As the dollar started to fall in value, oil prices began to climb. The dollar eventually fell to about 80 at the end of 2004 and oil prices were stronger. During 2005-2006 the dollar rose in value while crude oil prices also climbed higher - a period that appears to defy the normal pattern between the two.

The dollar's value began to decline in 2007, eventually falling to the 70 range as crude oil prices rose. The bottom in the value of the dollar coincided with the $147 peak in oil prices in July 2008. From that point forward, the dollar stabilized and began to rise in value as international investors along with U.S. ones recognized the security of the U.S. dollar in the face of the exploding global credit crisis. As the dollar's value rose, crude oil prices, along with the prices of virtually all commodities fell. Now we are seeing the inverse of that pattern as the U.S. dollar has been weakening as global investors become concerned about the impact of the magnitude of money being injected into the U.S. banking system and the huge increase in federal government spending due to the economic stimulus bills.


In the past two weeks U.S. credit markets have witnessed the announcement by the Federal Reserve that it will be injecting $1.125 billion into the banking system through the purchase of mortgages, debt of Fannie Mae to help support their mortgage lending efforts and longer-dated Treasury bills in an effort to lower the yield on government bonds. That action was followed by the Treasury's announcement of a plan to deal with toxic assets (loans and mortgage related instruments) on commercial bank balance sheets that are reportedly an inhibitor of bank lending.

We also had a phenomenon of officials from Russia, the European Union, EU member governments and the head of the European Central Bank criticizing the magnitude of the U.S. economic stimulus effort. The Bank of China's Governor authored a paper on the bank's web site suggesting the possible need for a new global reserve currency to replace the U.S. dollar. The U.S. Treasury Secretary Timothy Geithner initially suggested that the Chinese banker's idea was something worth considering, but he then quickly retracted that view and reiterated the U.S. government's official position that the dollar was, and would remain, a strong currency and the world's reserve currency. Of course between his initial remarks and his correction, the U.S. dollar's value fell dramatically, but did eventually recover. The impact of the weakening U.S. dollar and the corresponding rise in crude oil prices can be observed in the chart of the movement of these two indices over recent days.

The Chinese proposal was supported on Friday by a panel of economists who advise the United Nations. But what may be one of the most mind-altering proposals was a Congressional resolution introduced by Representative Michele Bachman (MN-R) that "would bar the dollar from being replaced by any foreign currency." We shake our head at the lack of understanding that the Chinese are


proposing a new "reserve currency" and not the replacement of the U.S. dollar as our currency. I guess this is a case of legislate and then investigate, much as we have experienced with the economic stimulus bill.

If the Chinese proposal for a new global reserve currency has any merit (and we doubt it does in any concrete terms), what would be the impact on crude oil prices? We doubt there would be any since oil is denominated in U.S. dollars and traded globally with no problems. As a business economist pointed out Friday morning on one of the morning financial television shows, anybody with a supply of gold could establish a bank in London and declare their currency (gold backed) to be the new reserve currency for the world. Whether any government would shift its financial system to that new, self-declared reserve currency and require all financial transactions and trade be settled in the new currency is questionable. Maybe, if the institution sponsoring the new currency were solid enough, after 40-50 years, it might create a new reserve currency. Possibly political, economic and financial events could shorten the time frame, but near-term there shouldn't be any impact on oil prices.

Given the economic and financial stimulus actions underway, and the political battle over the proposed Obama Administration's government budget that has just started, we believe the backdrop for oil prices will be a weakening U.S. dollar value, albeit with brief periods of surging strength. That overall trend should help support crude oil prices in the low $50s range for the foreseeable future, baring a significant economic demand collapse or another financial crisis. Should more positive U.S. economic news emerge over the next few weeks, we would look for crude oil to solidify its base in that low $50s range. That would likely encourage producers to start shifting from their bunker mentality, driven by the damage done to their balance sheets and cash flows from 2008's oil price collapse, to a slightly more optimistic outlook. Unfortunately, an improved oil price outlook won't help them particularly in dealing with the growing challenges posed by trends in the North America natural gas market that are wrecking havoc on the domestic oilfield service industry.

Another consideration regarding any shift in producers' market outlooks is that they cannot overtly reflect this optimism since it would encourage oilfield service companies to stand firm against the pressure to reduce prices. With crude oil in the low $50s range, a number of marginal exploration and development projects become profitable. But successfully forcing drilling rig and oilfield service costs down across the board might actually have a greater impact on producer company profitability than the additional marginal projects that suddenly become profitable. Of course what we are describing is the natural struggle between producers and service companies over what are fair levels of industry profitability. Until oil and gas prices go meaningfully higher from current levels, this struggle will be intense and neither side can react to the oil price recovery with glee.

G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.


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John Grosso | Apr. 2, 2009
Another outstanding article by Allan Brooks. An examination of the price of crude and strength of the dollar is an issue that should be tied to the supply demand analysis.

Well done!

Carlo Capitanio | Apr. 2, 2009
I believe regarding this connection price of oil and USD value. As most of the oil companies made a huge investments recently pushed by the high oil price, they will reduce a lot this investments in the 2010 because they need to have the price above 70 usd/barrel. But to keep or continue to recover the economy I personally believe that a price between 45-65 would be beneficial for our industry to keep a certain number of rigs drilling and at same time the cost of energy will be stabilized in a range that it will not harm families life cost and US-Eurpean industries can be competitive in respect to the asia-pacific area.

At same time combined with the stop to "printing money" to give some strength to USD which needs to recover around 1,2 against Euro a minumum to be competitive and try to avoid that investors move the money from US Bank to europena bank which offer better protection at the moment and a higher interest rate.

Jack Ferguson | Apr. 2, 2009
Isn't it about time for oil to be priced at demand levels for say China rather than as a play on the dollar which will likely continue to fall

CC Tam | Apr. 1, 2009
China might be taking the lesson from Japan during the past decades regarding a new "reserve currency". Japan accumulated vast foreign exchange reserves during the boom years but saw their value decline after repeated devaluation of US Dollar.

Another factor might be the fact that China is now the largest producer of gold. The proposed new "reserve currency" can be backed by gold as your article suggests.

William L. Linebaugh | Apr. 1, 2009
This is right on the money, I have been talking to my friends about this for years. I am a driller on a oil gas rig and my company (xtremeciol drilling) has shipped two large rigs to Mexico, leaving the smaller rigs with a lower charge to start up (hopefully) this summer. They will be drilling for gas at a much cheaper price. Disclaimer; I am just a Driller and have no say or incite to these decisions. I just want to go back to work and have been watching the Company so I'll have a better idea of when we go back to work.

With the Obama administration shutting down leases in the US and raising taxes, it looks to me like overseas drilling rather then domestic, only time will tell. Obama is a bit of a mystery but one thing is for share, he will print money until it's worthless.


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