The Financialization of Oil and Why it No Longer Works
Whytecliff Financial Corp.
By Bradley James Parkes, FCSI, G.I.T.
Oil is arguably the world’s most important commodity that is traded on financial markets. Water and air is more important to human existence, however, the former is a locally regulated market in most instances and the second is an underappreciated global “free” commodity.
Crude oil is hydrocarbon chain produced from the microscopic pores of sedimentary rocks found buried with in sedimentary basins around the globe. The origins of crude oil has been determined to be the remnants of plant and organic matter that was buried under sufficient pressure and temperature, a depth regarded as the oil window, that then migrates and forms reservoirs when trapped by a cap rock or geologic structure1. A number of sequential steps are required for an oil reservoir to form. Organic deposition, burial and hydrocarbon generation, migration and trapping with in a reservoir with a suitable sealing layer2. Missing a single step or having the steps happen in the incorrect order eliminates or reduces the potential for a sizable reservoir.
Ever since man began to harness combustion to heat his environment and eventually power machines the input combusted has gradually increased in energy density, also known as specific energy. Energy density, which is measured in Joules, and relates to the amount of energy stored in a volume or mass3. Gasoline has roughly three times the energy density of wood and natural gas is roughly five times that of combusted wood. Uranium, which has a higher specific energy than gasoline or methane4, but is less amenable to personal travel, has the highest specific energy of known substances, however, it is the portability and the ability to harness gasoline or methane for personal travel that creates the advantage for hydrocarbons as economic inputs.
Crude oil and natural gas are not only economic inputs, but also financial assets traded on futures exchanges. Futures exchange markets have been around for centuries in one form or another. The Dojima Rice Exchange in Osaka, Japan is believed to have originated in the late 16005 and the Dutch Tulip bubble of the 1630s utilized forward contracts in the later stages of the mania6. As future markets became less regulated and more open in the modern post World War II world an increasing number of participants have been attracted to the diversification and hedging factors of owning economic inputs as financial assets. As financial markets became deeper options to own economic inputs such as crude oil evolved from futures contracts, to options on futures to ETF, or exchange traded funds. As the products available increased the participants in these markets expanded from producers of the commodity, referred to as hedgers and speculators, to pension funds, mutual funds and eventually to retail investors7. This increased and expanded ownership has further enhanced the importance of crude oil as an input to society. There are few people who do not have some portion of their income, employment or retirement directly influenced by the pricing of crude oil. Some nations, such as those of the Middle East, have economies almost entirely based on the export of oil and in an attempt to influence and create a stable market set up a production quota cartel, known as Organization of Petroleum Exporting Countries, from now on referred to as OPEC.
OPEC is an odd entity. The members have less in common than one would imagine and act less coordinated than a successful cartel would. Within advanced industrial nations, the formation of pricing cartels generally violates some form of anti-trust law or pricing regulation8, however, the tolerance of OPEC has generally been observed by the advanced industrial nations, who are mostly importers of crude oil. To balance this market power, America negotiated with Saudi Arabia to price their exports exclusively in the US currency9. America, who has been the largest importer of crude oil for most of the past century, gained a semblance of control of the pricing, even though the supply determination was outside its power to determine. Notwithstanding this agreement, there have been instances where the two main parties, America and OPEC, have conflicted, such as retaliation by the Arab nations for support of Israel during the 1970’s creating supply shortages in North America and Europe10.
The widespread ownership, the cartelization of supply, the monopoly of pricing and importance as an economic input is why the oil market is such a complex and geopolitically important sector and why two pages of ink were spilled to introduce this report. The current turmoil in the energy markets have created a number of conspiracy theories as well as wide differences in opinion of what is likely to prevail going forward. However, a simple examination of the supply and demand, the different inputs and factors followed by an application of game theory should make the future direction and outcome of the current tug of war clear.
The US Dollar
The globally traded crude oil price benchmarks are priced exclusively in US dollars (USD). This not to say that there are no side agreements between nations, such as China and Russia, to price oil in other currencies, however, the reference prices are primarily quoted in US dollars. This feature of the oil market is the result of agreements between the United States and Saudi Arabia concluded in 1971 and 19739. This gives America some margin of control over the pricing of crude oil. As the USD increases in value, the price of oil becomes less expensive to American consumers, but more expensive to foreign nations and when the USD loses value versus other currencies the price of oil declines for foreign nations while increasing for American consumers. With America being the largest importer over the past century game theory suggests that America would maintain a reasonable value for oil imports and not depreciate the vast reserve of dollars the OPEC nations accumulate through their exports. Whether this is true can be debated amongst yourselves and would require an extensive report to determine, however, various conspiracy theories around the relationship suggest it has created an endless demand for USD and has allowed America to abuse the supposed exorbitant privilege granted to an issuer of a global reserve currency. For more details on exorbitant privilege one could referee to the works of the Belgian-American economist Robert Triffin (Triffin Paradox)11, however, economist Michael Pettis in Foreign Policy wrote a compelling critique of the consensus view of exorbitant privilege entitled An Exorbitant Burden12. It is not the goal of this report to debate the merits of issuing the world’s reserve currency, and the author is torn between the two arguments, however to determine what a USD is one must approach the debate.
To determine what oil is priced in one must figure out what the dollar is. Measure something, one needs to know the units of the measuring stick and whether the measuring stick is consistent over time. Under the post-World War II international financial system agreements, known colloquially as Bretton Woods, the USD was originally defined as weight of gold, originally fixed at $35 per oz. of gold, or 1/35th an oz. of gold is equivalent to a dollar13. However, since the collapse of the Bretton Woods system the dollar has become a financial asset, in addition to a currency, and is now obtains its value vs. a basket of currencies. This basket of currencies was a more diverse collection of currencies prior to the adoption of the Euro by the European Union and now the USD index (DXY), however, now the DXY is calculated as a geometric mean14 (with the associated weighting), relative to:
Euro (EUR), 57.6% weight
Japanese yen (JPY) 13.6% weight
Pound sterling (GBP), 11.9% weight
Canadian dollar (CAD), 9.1% weight
Swedish krona (SEK), 4.2% weight
Swiss franc (CHF) 3.6% weight
As one can see the DXY is primarily the affected by the value of the Euro Currency and a substantial weakness in the economies of Europe can have a drastic effect on the strength of the DXY and the pricing of crude oil. Prior to the creation of the Euro, only 37% of the basket of currencies was tied to the European continent (the five historical European currencies)15 were:
German mark (DEM), 20.8% weight
French franc (FRF), 13.1% weight
Italian lira (ITL), 9.0% weight
Dutch guilder (NLG), 8.3% weight
Belgium franc (BEF), 6.4% weight
This dynamic creates a forecasting dilemma for the energy exporting nations, for a rise or fall in the price of crude could theoretically be primarily related to an unstable exchange rate between the USD and the Euro and affect regional demand based on this relationship. An unintended consequence of this relationship is that when a nation devalues its currency to promote their export markets, they increase the value energy imports, decreasing the profits to businesses they are hoping to encourage to hire, limiting the effectiveness of the policy, however, policy recommendations are beyond the scope of this report, however, the author would be happy to tell you how to run the world over a beer, if you are buying.
To highlight this complex relationship between the high weighting of the Euro and the value of the DXY we present a chart of the DXY from after the collapse of Bretton Woods to prior the formation of the Euro and a chart of the DXY from post Euro adoption to the present date.
To determine the future outlook for the price of oil an analyst must first determine whether the changing value is due to supply and demand factors of the crude oil market or is it due to the complex relationship between financial assets (USD, Euro and futures price of crude oil baskets).
DXY Index Pre-Euro Adoption
DXY Index Post-Euro Adoption
Even with just a quick glance at the two charts one can see the drastically different behavior of the DXY. In the two charts we have highlighted the different action of the dollar with three colours, yellow for a range bound DXY, green for a declining DXY and red for a rising DXY. In the post Euro adoption, the overall range of DXY valuation has been smaller (24% range vs. 64%), but the trend has been primarily for a weaker dollar (16% lower - green), punctuated by short rallies that peak at the end of recessions (red line). Whereas in the pre-Euro era the value of the DXY over 20 years was roughly the same (7% lower) and the flight to the dollar in recessions was less pronounced or non-existent. This suggests the price of crude oil over the 20 year pre-Euro era was more supply vs. demand driven than in the post Euro adoption era, where it has been primarily a dollar weakness event.
How does the price of crude react to the DXY changes? The below chart of crude oil priced in USD shows the different trends with respect to the DXY index. The general price trend of crude oil follows inversely to the price of the DXY index. This is significant, because with the new construction of the DXY, being mostly an anti-Euro index, oil has become a derivative of the European currency.
However, when one views the ratio of West Texas Intermediate (WTI) at Cushing priced in USD to the price of an oz. of gold priced in USD (unfortunately WTI data only goes back to 1986) you can see the ratio has been more range bound, depicted by the orange lines and the effect the declining DXY has had on the price of WTI (purple line). When priced in USD the price of oil has increased from $15 to the current $100, however, over the 25 year ratio of these two commodities, the range is substantially smaller, notwithstanding the apparent volatility. The DXY trends since 1986 have been overlain on the chart in boxes. The red boxes are periods of DXY strength, where the price of oil should be declining, green are periods of DXY weakness and the price of oil should be rising and yellow represents DXY stability. Only the green box since 2002 and the red box from 2008-2009 has the WTI/gold ratio reflected this relationship, as gold has also become a derivative of the Euro. It appears we are in an era where the DXY has much larger effect on the price of WTI. This is significant because investment decisions are being based the value of the DXY and not supply and demand.
In fact for much of 2013 and 2014 while the DXY index was stable, the price of oil was stable as well. We are in an environment where the DXY index has as much influence on the price of crude as the supply and demand situation.
Global Economic Trends
Between 1985 and 2000 (we are ignoring pre-1985 for the oil price data on the STL Fed data site is only available from 1985 on) global GDP increased from $12 trillion USD to $30 trillion USD or 250%. This is significant because the price of crude oil is stable over that period of time while the dollar declines from a peak in 1985 (a result of the Plaza Accord) suggesting that oil supply decisions (and the resulting price) were reacting to demand and not DXY movement.
Since 2000 the global GDP has approximately doubled from $32 trillion to $72 trillion USD. However, much of that period included a decline in the USD, making foreign growth worth more in USD terms. During this period of time oil increased 300%, amplified by the weakness in the DXY. This suggests that since the DXY index became weighted exclusively against the Euro, the trend in the DXY has influenced oil supply decisions more than oil demand.
The GDP trend seems unlikely to continue in a strong dollar environment, Europe is in recession and Chinese growth rates declining. This suggests that the price of oil should continue to decline, but provide little stimulus to the rest of the world.
The interesting point about China, is that Chinese growth rates have declined, however, the net expansion of Chinese GDP is still approximately the same. While China barely grows at a 7% rate these days, the contribution to global GDP is as large as it was when the growth rate was north of 10%. To quote the IMF16:
“A bigger but somewhat slower growing China of the future will contribute about as much to global demand as the smaller but faster growing China of before. This is arithmetic: An economy that is twice as big can grow by ½ as much and contribute the same to global demand. By the way, China today is more than twice as big as it was a decade ago.”
This can be seen in the below pie chart from the IMF article16.
What has changed is the composition of commodity consumption. This could be the black swan the oil market has not priced in. As China transitions from an export driven economy to a consumption driven economy the composition of economic imports will change. If motor vehicles become desired over factory output the importation of more crude oil and less coal could be the result.
The above chart showing growth expectations from the IMF for industrialized countries shows how growth has declined for all but the Philippines, US, UK and Spain in 2014 vs 2010. Prior to the American energy revolution this would be a bullish factor for the global crude market but with American crude imports declining substantially since 2010, this hardly suggests that global growth and energy demand will be the factor that balances the market. It appears that for the crude oil market to come to balance it will have to do so through supply or at a lower price that spurs demand, due to an increase in the value of the USD.
Marginal Barrel of Supply
Commodity markets are priced on the margin. It is the marginal producer and marginal consumer that moves the market. It is that last buyer who drives the market out of balance to the upside and that last producer that drives the market out of balance to the downside. To bring the market back into balance the marginal barrel of production must be eliminated.
In 1998, American political economist Jude Wanniski gave a speech entitled Thinking on the Margin 17that included the following metaphor about the effect of the thinking on the margin that applies here to the last barrel of crude supplied:
“Everyone knows about "the straw that broke the camel's back." It is always that "last straw" that causes a change in the situation, the marginal straw, even though it weighs exactly the same as each of the other 10,000. But it is one thing to see that change occurs on the margin and quite another to understand that each straw is equally to blame for the breaking of the camel's back. Very few people think on the margin, but everyone acts on the margin, which is why it is so hard to see that the electorate, as a whole, understands economics.
To get our meaning, consider the camel again. He does not blame the last straw for breaking his back, but all 10,001. If straws could think, though, each of the first 10,000 would not blame themselves for doing in the camel, but would blame the last. The last straw, seeing clearly that his addition caused the camel to break down, would be the only one of the 10,001 to both act and think on the margin. If the straws were replaced by an equivalent weight contained in one log, which had a single mind, that log would both break the camel's back and understand that it had caused the event....”
Applying this quote to the futures market and economic analysis, the futures price is like the camel. It does not care which of the barrels of oil broke the price trend for all the barrels weigh equally. However, to analyse the market in some meaningful way we must think more like the straws and figure out which barrels broke the “back” of the market.
Throughout this report a theme has been we have been in an era where the value of the DXY index has had an oversized influence on the price crude oil and this has influenced production and demand decisions. A valid question is how has monetary policy affected the price of crude oil?
By all accounts the recovery in the United States has been subpar, with investment and employment recovering at rates slower than previous recessions. The blog Calculated Risk produced a chart widely known as the “scariest chart ever” depicting the rate of employment growth in the recovery of this recession vs. previous periods of economic stagnation. As you can see in the chart below, not only were the job losses larger than previous Post-WW II recessions the length of time to recover the job loses took approximately twice as long.
This slow job creation lead the Federal Reserve to implement monetary policy in an unconventional manner, referred to as Quantitative Easing18. The definition of QE can be found all over the internet and will not be discussed here, however, we will quickly state that it was implemented with the goal of providing extra stimulus to the US economy beyond the incentives of lowering interests by purchasing bonds and providing liquidity to the economy.
The below chart shows the overlay of monetary base, what the FED expanded during the different QE programs, and the price of oil. What can be seen in the chart is that there appears to be a correlation between spikes in the price of oil and a rising monetary base and the recent downturn in the price of oil coincides with the end of the Quantitative Easing. This fits with the theme of this report, in that the price of oil has been overly affected by the value of the DXY index and by monetary policy. This trickled through the energy sector and created an artificial boom in production and employment.
The next set of charts shows how monetary policy and its effect on price of crude oil has helped the FED achieve its goal of stimulating the economy and reducing unemployment. The first chart shows the employment growth of the mining and oil sector vs. the unemployment rate. In the time frame between the first phase of QE, known as QE1 and the second phase, QE2, the mining and energy sector started expanding employment and at the same time total unemployment began to fall.
The next chart shows this in more detail as it depicts the employment growth of five states with major shale projects vs. 45 other states in America. Until recently, all of the net job growth in the US economy has taken place in states with shale projects. One can argue that the QE programs have been successful in achieving the goal of spurring employment in the US economy, as now the growth seems self sustaining enough that the other 45 states are now about to add net job growth for the first time since pre-2008. However, this is happening at the time where the net job expansion in the shale states are starting to decline, and will decline further with the recent crash in the price of oil. The unintended effect of QE was to break the back of the camel, will this create a negative feedback loop? It will if American shale production is the marginal barrel.
Effect to the Global Economy
This system worked well while the United States was the largest importer of crude energy19. As the USD weakened, the price in USD would increase, but would become less expensive for the rest of the world. This would spur demand in the rest of the world and lower costs of export to the US, which is also the consumer of last resort for the world. As the USD, strengthened the imports of crude oil to the US would decrease in cost and leave extra money to purchase extra goods from the rest of the world. Now as the USD is just the reverse of the Euro it plays the American economy off the European economy and forces emerging markets to maintain an ever changing basket of reserve currencies. The only way for the rest of the globe to grow is for a never ending decline in the USD to take hold. As everyone knows, trades cannot go one way forever.
Now as the US has become closer to being energy independent, as shale production has increased American crude output, the trade deficit declines and the dollar strengthens, making crude oil more expensive for the rest of the world, while the US no longer picks up the slack from extra crude oil supplies on global markets. This series of events leads to a global crude surplus further weakening the exporting nations, while at the same time increasing the import cost for emerging markets. This makes global recoveries almost impossible to be maintained in the US, Eurozone and emerging markets simultaneously.
The relationship that financialized crude oil no longer functions in the manner that made it a successful system for the past 40 years. This relationship of using the USD to price global crude oil worked as long as America was the largest importer and the USD was not the inverse of a single monetary region. Under this system when the DXY, the global measure of the USD rose, oil became cheaper for the US economy and more oil was imported. The producing nations would peg their currencies to the USD and the increasing purchasing power of their reserves would allow increased imports from Europe and Asia, thus providing a boost to their economies. When the USD weakened, the price of oil would increase in the US economy and decline in the Asian and European markets and provide cheaper inputs to create the exports that would be purchased by dollarized economies. This ebb and flow required that oil imports were absorbed by the reserve currency issuer. The system has begun to break down because America no longer needs to import as much oil from the producing nations. This crack in the system did not become apparent until the DXY began to rise in purchasing power.
This time when the DXY index began to rise, the cheaper oil was not absorbed by the US economy, due to rising production and because the DXY is now an inverse to the Euro, the price of oil in Euros increases at a time when the EU economy is already weak, creating a further weaknesses.
This is why the Saudi’s first move was to discount the price of Asian oil exports to protect market share and combat the increase in the DXY. The reserve currency issuer HAS TO BE THE LARGEST OIL IMPORTER for this system to function smoothly and to create the ebb and flow already mentioned.
The stronger dollar is causing relative inflation to the weaker nations and the increase in US domestic production is not absorbing the excess supply. This is why the second part of the OPEC plan is to kill the marginal barrel in the US.
If OPEC is successful in killing the marginal barrel the ramifications is that there will be a return to unconventional monetary policy and a delay to energy independence and a return to a price range of $70-90 USD per barrel of crude. This time the US production response will be slower to react to the price incentives, because like Mark Twain’s cat who sat on a hot stove and would not sit on any stove going forward the high yield bond market will be less likely to advance the required sums to advance the marginal barrel projects.
Looking back on this period of events in the future on thing may become clear, to paraphrase Mark Twain again, the death of OPEC may have been highly exaggerated and that non-OPEC energy producers should have adapted to protect their balance sheets against the stronger USD. Hedging oil revenues in gold, creating an unofficial Bretton Woods system, will become imperative. This should offer some protection against financial driven swings in the price of crude oil and eliminate the oversized influence of the DXY on crude oil prices.
Another lesson of hindsight is that investment and production decisions cannot be based solely on price and cash flow generation, and must rely more on the idea of balance sheet stabilization. The boom/bust cycle must be dampened by avoiding the desire to be “all in” followed by “all out”. The final lesson of this era, especially in the light of America’s drive to continue to seek energy independence, and this lesson can be extended to other financialized commodities, is that commodities should be priced in a basket of currencies, or even in Special Drawing Receipts (a ready-made basket of currencies created by the IMF to facilitate international trade). The system of financializing commodities through the monopoly pricing in a single currency works as long as the reserve currency issuer is the world’s largest importer, or purchaser of last resort and the reserve currency value is based on a wide variety of competing currencies and not dominated by the inversion of a single region. Similar problems have begun to appear in the price of copper and exist in the gold market.
A failure to head these policy recommendations will continue to create malinvestment in extractive resources and further amplify the boom bust cycles and impoverish producing nations at the expense of the reserve currency nation.
5- Moss, David A, Kintgen, Eugene: The Dojima Rice Market and the Origins of Futures Trading. Harvard Business Review. (2009)
6- Dash, Mike. TULIPOMANIA. The Story of the World's Most Coveted Flower. Crown Publisher (2000)
7- Simon, Matt. Options on Futures:A Market Primed For Further Expansion. CME Group (2014)
8- Cartels and Anti-Competitive Agreements. OECD. https://www.oecd.org/competition/cartels/
9- Cooper, Scott A. The Oil Kings: How the U.S., Iran, and Saudi Arabia Changed the Balance of Power in the Middle East. Simon and Schuster. (2012)
12- Pettis, Michael. An Exorbinant Burden. Foreign Policy. (2011). https://foreignpolicy.com/2011/09/07/an-exorbitant-burden/
16- Barnett, Steven. Size Matters. iMFdirect (2014). http://blog-imfdirect.imf.org/2014/03/26/china-size-matters/
17- Wanniski, Jude. Thinking on the Margin. (1998). http://www.polyconomics.com/ssu/ssu-980123.htm
18- What is Quantitative Easing? The Economist. (2015). http://www.economist.com/blogs/economist-explains/2015/03/economist-explains-5
20- US Could be Energy Independent within Four Years. CNN (2015). http://money.cnn.com/2015/04/15/investing/us-energy-independence/
1- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/series/TWEXMPA
2- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/series/TWEXMPA
3- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/series/MCOILWTICO
4- Created with data from the St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/series/MCOILWTICO
5- Carlson, Andrew J. BCU Chart - USD vs. Crude Oil Prices. (2014)
6- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/series/MKTGDP1WA646NWDB
7- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/series/MKTGDP1WA646NWDB
8- Barnett, Steven. Size Matters. iMFdirect (2014). http://blog-imfdirect.imf.org/2014/03/26/china-size-matters/
9- Carlson, Andrew J. BCU Chart – IMF Growth Expectations. (2014)
10- Worst Jobs Chart in World. Calculated Risk Finance and Economics. (2014) http://www.calculatedriskblog.com/2014/06/may-employment-report-217000-jobs-63.html
11- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/graph/fredgraph.jpg?hires=1&g=3eg9
12- St. Louis Federal Reserve FRED. https://research.stlouisfed.org/fred2/graph/fredgraph.jpg?hires=1&g=3egk
13- ZeroHedge. (2014) http://www.zerohedge.com/news/2014-12-06/jobs-shale-debt-and-minsky