Assessing the impact of the current oil situation and 2008 prospects

Let's consider the following points:

Re the USD (part 1):

1. The fall in the dollar's value since August 2007 has taken place against a backdrop of a slightly improving US trade deficit.

2. From point 1., it is just logical to deduce that, if the US trade deficit had instead worsened during that period, the dollar would have fallen further.


Re crude oil prices and supply/demand balance:

3.
On Nov 20, 2006 WTI = $59 and EUR = $1.28, so WTI = EUR 46.
On Nov 20, 2007 WTI = $98 and EUR = $1.48, so WTI = EUR 66.
That's for a WTI price rise of 66% in dollars and 44% in euros in a year.

4. This yearly WTI price rise cannot be explained by Iran-related geopolitical tensions, which were actually higher a year ago. It cannot be explained by speculative pressure either, since NYMEX net positions a year ago and now are fairly similar. Therefore the price rise can only be explained by a deterioration in physical supply and demand balance.

5. To support the inference in point 4., it's worth noting that,
on Nov 21, 2005 WTI = $58 and EUR = $1.18, so WTI = EUR 49.

However, on Nov 2005 speculative positions at NYMEX were net short at historic record levels, so a year later we had both increased speculative pressure and increased geopolitical tensions, yet the oil price was roughly the same. Therefore, reasoning like in point 4., we deduce that supply and demand balance should have improved during 2006. And indeed, as we see in the IEA Oil Market Report (OMR) at http://omrpublic.iea.org/, total OECD closing stocks were:
for 4Q2005, 4083 mb amounting to 81 days of forward demand
for 4Q2006, 4180 mb amounting to 84 days of forward demand

6. In contrast, and adding support to point 4., OECD closing stocks for 2Q2007 were the same as for 2Q2006 (in mb and days). But more importantly, OECD stocks experienced a net *draw* of 380 kb/d during 3Q2007, contrasting with a 1160 kb/d net *build* in 3Q2006, and an average 280 kb/d 3Q net *build* over the past five years (and anecdotically, with Japanese crude stocks falling to their lowest level in at least 20 years.) Which clearly shows the worsening in supply/demand balance over 2007.


Re oil production:

7. According to the EIA, world oil production peaked on a monthly basis on May 2005 for (Crude Oil + lease condensate = CO) as well as for (Crude Oil + lease condensate + Natural Gas Plant Liquids = CO + NGL). If we consider All Liquids (which includes biofuels) then the peak month was July 2006.

8. Also from the EIA, for all 3 categories (CO, CO +NGL and All Liquids), production for the first half of 2007 has been the same as (actually slightly lower than) that for the first half of 2006 (73.23 vs 73.48, 81.20 vs 81.26, and 84.28 vs 84.35 mb/d respectively).

9. There are strong reasons that expect that 2008 world oil production will not be higher than in 2007, as shown by Stuart Staniford at
http://www.theoildrum.com/node/3236


Re oil demand and price projection:

10. According to the latest (Nov 13) IEA OMR, average global oil demand was/is expected to be:
for 2006: 84.7 mb/d
for 2007: 85.7 mb/d (+1.2%)
for 2008: 87.7 mb/d (+2.3%)

11. Therefore, with constant production over the 3 years, if a 1.2% increase in demand caused in 44% increase in price in euros, a 2.3% increase in demand can be expected to cause a 44 x 2.3/1.2 = 84% price increase in euros, to a price in Nov 2008 of EUR 121. Assuming EURUSD stays at 1.48, that's $180. (Realistically, it is very unlikely that stocks experience such big drawdowns during 2008 as to meet all of the projected demand. Rather, the estimated price can be reasonably thought of as that needed for causing the amount of demand destruction that will allow stocks to remain at acceptable levels.)


Re the USD (part 2) and the US economy.

12. However, the EURUSD = 1.48 (and consequent WTI = $180) assumption in point 11. may not be realistic for the following reasons:

a. If US oil and petroleum products imports remain constant, an 84% increase in the oil price can be expected to cause the US trade deficit to worsen, which in turn can be expected to cause a further fall in the dollar (as per points 1. and 2.).

b. An 84% oil price rise will greatly increase the current account surplus of oil exporters and as a result their foreign exchange reserves, very likely to the point of compelling them to at last unpeg their currencies from the dollar and further diversify their foreign exchange reserves from it.

c. Moreover, the $200+ oil price expected to result from factors a. and b. can in turn be expected to increase the pressure for oil exporters to start pricing and trading their resource in other currency/ies, thus adding further downward pressure to the dollar and conceivably taking it to its "Wily E. Coyote moment".

13. In assessing the impact of a doubling of the oil price on the US economy, (neo)classical economic analysis can be expected to point out that the share of energy in US GDP is still low. Recent oil price action, however, shows how easy it is for the oil price to double, and a doubling here, a doubling there, and pretty soon you're talking about real share. Therefore a $200+ oil price (which BTW assumes peace and love between the US and Iran) can be reasonably expected to add significant inflationary pressures in the US. If, however, the US Federal Reserve adjusts its monetary policy REACTING to those inflationary pressures once they are manifest, it is very likely that by then the dollar will have already lost a substantial part of its international trade and reserve currency status.


Conclusion:

The currently expected oil supply and demand situation for 2008 portends at least a doubling in the dollar oil price and poses a significant risk of triggering the much-feared collapse in the dollar value. The only alternative is a significant "endogenous" (i.e. not due to higher oil prices) reduction in oil consumption in the main consumers (US, Europe and China, in that order). Which in turn can be reasonably expected to occur only as a result of a US-led OECD recession (causing a Chinese deceleration of economic growth). A new Fed monetary policy focused on the preservation of the dollar value for international transactions through checking its global supply growth can do the trick.

If the ECB does not have the nerve to follow a similar path, and issues whatever amounts of euros are needed e.g. to prevent any recession to happen or any bank from falling, that will lay to rest the expectations of the euro challenging the dollar status as the main international trade and reserve currency.