Is the Falling Dollar Boosting Crude Prices?

OPEC's policy allows an increase in crude oil production when prices exceed $28 a barrel for 20 days. That just happened. So far, no boost. What's up?

On January 2, OPEC's basket of seven crude oils passed 20 consecutive days of prices above $28. OPEC's target is to hold prices within a band of $22 to $28. OPEC has a policy that 20 days above the upper end of this target can trigger a 500,000 barrel-per-day production increase to bring the price down. This is an informal mechanism OPEC has created so members can act immediately if prices break out too high above its upper limit.

Why then has OPEC not added production to bring the price down? Certainly there has been wide vocal support for such a move. One analyst saw it a virtually a broken promise: "Their decision to ignore the trigger mechanism, which was intended to keep prices between $22 and $28 a barrel, helped bury the long-held assumption that $28 was the cartel's highest tolerated price."

The $22 to $28 price band is one of the cornerstones of OPEC's business plan. Prices in this range, OPEC says, are fair to consumers and producers alike. And they avoid the boom-bust cycles that have historically plagued the oil industry. Why then did OPEC not act?

The first answer is: it is not mandatory. OPEC can decide if a breakout requires a response, and when. And it may yet do so. However, OPEC in December scheduled an extraordinary session Feb 10 to reexamine prices and production adjustments and deal with just such a situation as it faces today. Certainly in most business situations, 30 days is plenty of time.

And the second answer is that many OPEC members have said they don't believe that current prices above the target range are a result of normal market pressures.

The Almighty Dollar
In recent months the view has grown among OPEC members that the declining value of the U.S. dollar is forcing oil prices up.

At the end of its December Conference in Vienna, OPEC said, "... the relative strength in current market prices, with the price of the OPEC Reference Basket having fluctuated around the upper limit of the OPEC price band in recent weeks, the Conference acknowledged that this is partially a reflection of prevailing geopolitical concerns and, therefore, warrants continued careful observation. In this connection, the Conference also noted, with some concern, the decline in the purchasing power of the barrel as a result of current US dollar weakness vis-à-vis other major currencies."

OPEC pegs its oil price to the U.S. Dollar. When the dollar value decreases, OPEC members receive a lower value when dollar sales are translated into their own currencies. OPEC's real income drops. "For producers, the dollar's sliding trend is a cause of concern as some member countries have strong trade links with Eurozone countries. The dollar's continued move downward against the euro will only further undermine the purchasing power of the barrel," OPEC said in its monthly oil market report.

Europeans, converting euros to dollars to pay for oil, are coming out ahead. Their oil prices have dropped as the euro climbs against the dollar. Imports from Europe are becoming more expensive.

Others in OPEC and outside the organization believe price results more from factors not directly related to the dollar's decline, among them the rise of China's economy and political uncertainty in nations with substantial oil reserves: chiefly Iraq, Russia, Venezuela and Saudi Arabia.

Producer Actions
Further uncertainty comes from the political situation in Russia, the second largest oil exporter after Saudi Arabia and not an OPEC member. Russian output is still expected to rise this year, but analysts remain jittery as President Vladimir Putin seeks to exert greater government control over the nation's oil industry. Until the arrest of Mikhail Khodorkovsky, the former chief executive of Yukos, the nation's largest oil company, the industry had appeared to be ready for huge infusions of Western investment. Still, if things clear up as they might. OPEC could see a large flow of oil into the marketplace.

OPEC president Purnomo Yusglantoros plans a visit shortly to Russia.

Kazakhstan's president Nursultan Nazarbayev is on record as saying the countries near the Caspian Sea should form a regional oil organization similar to OPEC. Kazakhstan, Azerbaijan and Turkmenistan in the region have large oil deposits. Iran is the only OPEC member country bordering the Caspian.

Other uncertainties relate to Venezuela, where President Hugo Chavez faces a recall election, and Nigeria, where the recent replacement of the oil minister prompts speculation as to whether Nigeria would remain a faithful OPEC member. Finally, there are concerns over the Saudi Arabian government's dealing with a recent upswing in terror attacks with the potential to develop in into a threat to economic stability and the oil infrastructure.

Demand Price Pressures
On the demand side, China presents an ever-increasing demand for oil and has passed Japan as the world's second largest oil market. Upward pressure on prices from China's demand will continue as the Chinese economy grows. Stronger demand in China and other Asian countries is one reason OPEC decided not to cut production at its last meeting in Vienna in December, leaving in place its current production limit of 24.5 million barrels a day.

OPEC is up against a hard problem in trying to decide what to do. That's probably a main reason why it will do nothing until its next extraordinary session Feb 10. What it does then will be determined by economics – dusted with politics. If the China economy continues to grow and Japan stays busy, supplies may have to be loosened to hold price down. But the dollar needs to firm up also to make that move attractive to OPEC. On the other hand, a pickup in production from Russia and Venezuela combined with continued weakness in the dollar could cause a downward pressure on prices. Not least, continued high crude prices will call out the U.S. government's jawboners to try to talk prices down. But then every day the dollar weakens, so does their stroke.