Why the oil price must rise as the $ falls.

When the $ falls the oil price falls in all the currencies that the $ falls against.   A rise in the $ price of oil of $7.5 is a 10% rise but not if the € rises the same amount as the oil price rises.   If that happens the price of oil in Europe remains constant.   But is life that simple....?

We are fully aware that the $ is falling for a multitude of reasons at the moment.   But it started with a persistent Trade Deficit that essentially allowed the U.S. to print dollars for export.   This made it the only country in the world receive goods without earning the money to pay for them.    As far as the extent of the Trade Deficit, it was a policy of "live now, pay later".   At times, the annual Trade Deficit ran at $720 billion per annum.   Oil producers and the producers of cheap goods imported into the States have been acquiring those dollars, building up frighteningly large reserves [China is over $2 trillion and rising].   The first suppuration of this problem came in August 2007, alongside the credit crunch.   This flowed over into a world banking crisis that is still not over and worse still has caused a recession in the developed world and its dependent nations.   With surplus holders now worried by the size of their $ holdings, these dollars are being spent on a range os assets as fast as possible.

China has and is proving to be able to avoid the impacts of this crisis.   The very size and synthesized structure of the nation allowed it to turn a first quarter of 2009 slowdown into an accelerating growth pattern that is now running in double digits again.   Alongside this is its rising need for oil.      Global oil demand must rise with the accelerating recovery.   Oil supplies, while they are starting to grow have a huge way to go to supply a 'recovery demand' with the future additional demand from China.   The big question is, "can it?"

A prime reason why the $ became the world's prime reserve currency on top of its economic power, was the link to the oil price.   For all of the last 40 years of last century, oil was priced in the U.S. $ alone.   Until now this has been the situation in this century.   Yes, Iran is trying to walk the € road with its oil price, but for mainly political reasons.

But now Russia and China have agreed major oil and gas deals that may well be priced in either the Rouble of the Yuan.   Will this affect the $?   Yes, indeed.   Any fall in the use of the U.S. $ in the oil market releases those dollars into other markets, unable to absorb them.   If this practice were to continue and other oil producers accepted currencies other than the U.S.$ more dollars would flow into the foreign exchange markets of the world, where they will prove too much and the $ will fall relative to other currencies as these dollars look for a home.

Now turn to the oil price and a falling U.S.$ exchange rate.   Imagine you are an oil producer and you receive $75 a barrel for your oil from all countries of the world.   Your resources are a limited wasting asset and you want as much income from it as your customers can afford without damaging their economies, so because of a recession you accepted a drop in your income to $35 a barrel when the credit crunch hit.   But the moment that happened you could not afford to develop new oilfields and were in danger of your own economy stagnating.   [In Dubai, where 20% of the world's cranes were employed in developing that country, projects dried up fast.]   So you determined that you needed $70 to $75 per barrel to resuscitate development and to continue to find new oilfields to supply the world with.   Then the $ started to fall from $1.20: €1 down to $1.50: €1.   With no inflation around, your U.S. income didn't change at all.   It bought just as many hamburgers as it did before the fall.   But the rest of the world in nations that enjoyed the dollar's fall they got a discount on their oil to the extent of $1.2/$1.5, a 25% oil price reduction in their own currencies.

Now this meant that while you could buy as many hamburgers in the States as before, you got 25% less hamburgers worth than before in the strong currency countries who really did not need the discount.   Ah, you say, but with those dollars you can take them from non-U.S. customers and still buy as many hamburgers as before provided you buy them in the States.   What to do, you ask as an oil producer?  

This meant you will have a growing dependence on the U.S., which is great for the U.S. as leading world power, but your future is a global one.   When you see the rise of Asia and in particular China, you realize that you don't have to suffer the discount on other currencies if you price you oil in those other currencies.    But you need the military backing of the U.S. to fortify your grip on your home country, so quid pro quo, you can't price oil in other currencies.   What alternatives do you have?   You have got to remove that discount by letting the $ price of your oil rise to compensate for the fall in the $, then you have a relatively stable, global oil price?

But in global markets the rise in the oil price can be seen as punitive greed by oil producers, particularly in the States where they feel the bite.   While that is due to a declining exchange rate of the $, the political buck is tossed onto the oil producers.  

But there is more to this than that simple facet.   Oil is a wasting asset and clearly if the world resumed the growth and vibrance it had in July 2007 and China plus India continues to grow as they are, then the probability of there not being enough oil to go around would arise.   When the oil price was $145, it was because speculators/investors, plus users, were discounting that likely scene.   As the demand dropped when the recession hit the bubble burst and back to $35 a barrel we went.   But once the recovery really gains traction, what then?   The U.S. will suffer not only a rising oil price, due to demand, but the decline in the international buying power of the $ as its exchange rate falls.

Today with an $80 oil price at a time when O.P.E.C. favors a $70 to $75 oil price range the present rise is due to the falling $.   If the oil market remains stable at these prices and the $ falls to $1.70, then a price in the U.S. $ that reflects this fall will be $99 a barrel.  

So will all oil producers accept the $ in the oil market?   Oil is entirely global so why not accept different currencies from different countries [limited of course to those that are developed or getting there on their own steam]?   This has started.   

With Russia now producing more oil than Saudi Arabia this will be a blow to $ pricing of oil.  With the $ weak anyway, any internationally held dollars will slowly become excessive in the market place, hastening the fall of the $.   If O.P.E.C. turned to that practice [a most unlikely event at the moment], then the $ would go into freefall and inflation would be imported into the States in a rush.

The pressure is on to change the pricing of oil as the growing volume of U.S. dollars exits the U.S.   They are currently being spent as fast as possible by surplus holders but this is not fast enough.   At some point in time, either the huge supply coming out of the States will meet the dropping desire to hold them and the price will tumble, taking the global monetary system into very dark days.

With the dollar being the hub of the monetary world, what alternatives are there.   While gold will preserve value in such a world, it is not in a position to return to a means of exchange at a commercial level.

For more of this type of analysis from Julian D.W. Phillips on currencies, oil, Gold and Silver,  Subscribe to The Gold Forecaster - Global Watch or the Silver Forecaster, through  www.GoldForecaster.com or www.SilverForecaster.com

This author consults with leading institutions through GLG