The Dollar and the Economics of Oil 4 th Jordan AFAQ Economic Forum Amman, Jordan May 7 & 8, 2012

Oil: Industrial Commodity or Market Commodity We still treat the oil market as commodity market, as driven primarily by supply and demand, perhaps because it is a tangible product, perhaps out of habit The strict supply and demand model for the oil market no longer applies We need to think of oil and many other international commodities as well, in the terms of the currency market That is, as a market whose short term prices are primarily driven by the search for trading profits In trading markets all factors, economic, financial, technological, political are price inputs, signals, that traders use to anticipate price movement, that is, to forecast the reactions of other traders and the search for trading profits Trading markets exhibit long term trends but their day to day price movements are volatile and driven by internal market reaction to changing external economic factors

Oil and the Demand Future Modern consumer society is built on cheap available energy Oil is the industrial world’s chief raw material and transport fuel No other industrial technology can provide the power, flexibility and availability of oil products and gasoline As the world industrializes the demand for oil will rise and not fall. Oil will remain the world’s chief raw material and chief transport fuel for the foreseeable future

Cars and Society The economic model of the modernizing world is the consumer society The personal automobile is one of its great symbols The United States today has over 260 million vehicles and 312 million people China has only 75 million vehicles, over 1.3 billion citizens and an economy that has grown faster than any other in history. The demand for inexpensive cars and efficient transport is the future The efficient gasoline powered car is the vehicle of the future

Oil Demand, Supply and Price Oil is becoming harder and more expensive to extract Oil is not running out The increasing demand for oil and its more difficult and expensive supply are the main reasons for the long term rising price of crude and its products Long term price movements are correlated with supply and demand Short term moves are internal market repositioning: example late 2008

Inflation Central banks have been successful in fighting inflation since the 1980’s

Oil and Inflation The Inflation adjusted oil price shows a similar price pattern to the non-adjusted price The volatility in oil is not an inflation based phenomenon The steady historical rise in oil has an inflation factor but it is minor Gold responds strongly to psychological factors in addition to inflation and supply and demand Inflation or anticipated inflation is not driving the price of oil

Oil and the International Market Four factors have helped oil become a trading market commodity, two are likely to be permanent, two temporary Permanent Worldwide markets and their 24 hours electronic facilitation Oil commodity market was effectively deregulated in the US in 2000 and the Intercontinental Exchange (ICE) established in in London Temporary Artificially low interest rates and the search for investment return Liquidity glut and weak return from interest and direct investment

Oil in the Dollar Market Oil is now an actively traded trading profit seeking volatile market Open interest has risen since 2000 far more than demand All factors affecting the oil market, world GDP, supply and demand, known reserves, political restraints on production, supply interruptions, interest rate policies as they affect the value of the dollar, have become oil trading market inputs Oil moves now much as currency markets do, in response to changes in inputs and the overall market scenario The current scenario is increasing demand (industrializing world primarily), tight supply, potential disruptions, neutral dollar (range against the euro past three months If any of these factors change or market perception changes then oil will move Example: Spain seeks a European bailout or defaults, the dollar soars, oil plummets. It will fall far more than the simple change in exchange rate for the dollar In the day to day and month to month price movement oil has far exceeded the volatility of supply and demand.

Does Dollar Price of Oil Matter? There is an inverse directional correlation between the dollar and oil but not a direct value translation From January 2002 to December 2008 crude oil moved inversely with the dollar in five of seven years Exceptions: In 2005 the dollar strengthened almost 13% against the euro and crude oil gained 51%, and in 2006 the dollar lost 12.5% and crude oil also fell 8.07%. In 2008 (July – October) oil collapsed from $147 to $61,58%, but the dollar rose only from , 23%, as the financial crisis devastated markets No other factor affecting oil dropped that percentage, not the rise in the dollar, not the drop in demand or projected drop in demand, there was no constriction in supply The collapse was the panic reaction of a trading market

Oil and the Future 2008 price volatility was an aberration Bubbles do not repeat in the same instrument Volatility post-crash is much higher, but so is economic political and policy uncertainty Long term trend is higher and is, despite the volatility relatively stable Demand will continue to rise as world industrializes Supply is higher but more costly Replacement is expensive Natural gas has potential but it is undeveloped as a replacement Oil is likely to remain the fuel of the next generation