Introduction

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.

 

Market Variables

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 continent15 (the five historical European currencies) 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).