Wednesday -- April 1, 2015

Active rigs:

	4/1/2015	04/01/2014	04/01/2013	04/01/2012	04/01/2011
Active Rigs	99	191	186	207	170

RBN Energy: how the dollar affects the price of oil.

RBN has documented many fundamental influences on crude oil prices including supply, demand and inventory levels as well as infrastructure constraints. One that we don’t often mention is the strength or weakness of the U.S. dollar. As with most international commodities - oil is bought and sold priced in U.S. dollars. As a result, a change in the value of the dollar relative to other currencies has an impact on oil prices. Likewise the dramatic fall in oil prices since June of 2014 has been mirrored by the dollar rising to levels not seen since 2003. Today we look at how oil prices are impacted by the value of the dollar.

Since the 1980’s crude prices have generally been determined through bilateral negotiation between counterparties based on differences in quality and location as well as other market fundamentals. Counterparties in these transactions typically make reference to widely traded benchmark crudes to link their deals to spot market prices and. We recently described the formula pricing system used by Saudi national oil company Aramco to determine the price buyers pay for their crude – based on a benchmark linked to destination and a monthly adjustment factor. All of these transactions are carried out using a single currency – the U.S. dollar. The reason why oil transactions take place in dollars dates back to the early dominance of the U.S. oil industry – that was originally the center of world production and the largest exporter in the 1930’s.

Since World War II the dollar has been the dominant reserve currency and most international commodity transactions are carried out in dollars for the convenience and security of both parties.

Of course, the fact that oil is priced in dollars provides U.S. companies an inherent advantage over their competitors in other countries. For one thing, buyers and sellers here do not have to pay currency exchange fees to buy or sell the dollars they use in crude trades. In addition to those fees they also avoid any currency risk associated with refining outside the U.S. For example, overseas refiners have to buy their crude using dollars and sell their refined products to consumers in the local currency – so that exchange rate fluctuations can end up costing them money if they do not hedge that risk.

One side effect of oil being priced in dollars is that large investors often take financial positions in oil (usually in paper form e.g. in the futures market) as a hedge against a decline in the value of the dollar. The theory behind these hedges is that if the dollar loses value against other currencies then the price of oil will increase to compensate for that weakness – protecting the investor from dollar deflation. Obviously that works the other way around as well – with a stronger dollar tending to push prices down. With oil being such a huge commodity these financial players have an influence on the physical crude market because of the strong links between oil futures markets and physical prices.

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Annus Horribilis

Queen Elizabeth II referred to 1992 at England's annus horribilis.

It is very likely that Saudi Arabia will see 2015 as their own annus horribilis.

This was the year that the US made it very clear that Saudi Arabia and the US had parted ways. Saudi was no longer guaranteed US protection, something guaranteed since 1933 by FDR.

It was the year that it also became clear that the dominant resident power in the Middle East would be Iran.

It was the year that, through gross miscalculation on their part, oil prices crashed.

And it was the year that Saudi Arabia was pretty much surrounded by the Shi-ites -- Iraq to the north; Iran to the East; Yemen to the south. Saudi Arabia had to resort to going to war on its own -- attacking Yemen -- and losing at least one fighter aircraft in the conflict -- which seems pretty hard to do going against Yemen.

There is some irony: I believe Iran is the only country in the Mideast to have global sanctions placed on exports, and yet, the country has a positive balance of trade in each of 70 sectors. I'm not sure the US can even claim that. I doubt Saudi Arabia even has 70 sectors in which it has a trading relationship. They have oil, that I know. 

Disclaimer: I often make factual errors in my opinion and comments. There may be factual errors above. If this information is important to you, go to the source.