Falling Oil Prices: The Monetary Hypothesis
Published in Egalité & Réconciliation
(France) on 5 January 2015
by Ian Purdom (link to original)
(France) on 5 January 2015
by Ian Purdom (link to original)
Translated from
by Michael Krimian.
Edited by Bora Mici.
The price of petroleum products has been falling relentlessly since last July, and has accelerated since last October. Whether one uses the Brent or WTI, the two main market oil price references, we are witnessing a real crash. The last similar occurrence happened back in 2008, a year in which the global economy suffered one of its most severe crises since World War II.
The chief argument presented by the mainstream media to explain this phenomenon is the slowing down of the economic situation, notably in China, which entails a downward revision of global consumption in 2015. In addition to global consumption, there is the stabilization of domestic production growth in the U.S., backed by unconventional petroleum products – a stabilization that keeps on tempering U.S. imports. We also hear different geopolitical takes on this story, with Saudi Arabia generally out front as it obstinately refuses – for various reasons – to lower its production. Considering the importance of Saudi Arabia in global production – about 30 percent – its position could force other exporting countries to follow Saudi Arabia’s lead.
Nonetheless, a precise figure analysis invites us to look further down for additional reasons to support these explanations. Indeed, according to the International Energy Agency, global oil production in 2014 was 91.96 billion barrels, and global consumption was 91.44. In 2015, the forecast is 92.75 billion and 93.32 billion respectively. While the gap between production and consumption increases, it is infinitesimal – far from capable of explaining a crash of this magnitude in oil prices, a crash, that is, more than 40 percent.
Yet, if we take a close look at the recent monetary situation, we can see that the fall in oil prices matches the end of QE3, the last of the quantitative easing programs which the Federal Reserve has been implementing since 2008. In fact, Federal Reserve Chairwoman Janet Yellen stopped the injections of liquidity into the banking system last October. In addition, the Fed is now clearly hinting that interest rates will go back up soon.
Quantitative easing and low interest rates simply translate into full-scale money-printing, and were policies implemented to addressing the financial crisis generated by the subprime. As many economists explained it, and notably Peter Schiff, who is known for having predicted the 2008 crisis, this ultra-accommodating strategy has a pernicious effect on the dollar, which loses value as the money supply increases.
Therefore, this change of pace from the Fed reinforces the value of the dollar vis-à-vis others currencies and also raw materials. As we can see, raw materials have lost value vis-à-vis the dollar recently. Nevertheless, it appears oil has suffered a lot more than the others .
This oil overexposure can be explained by its central position in our economies, and also by the way it is handled on financial markets.
Since the end of the automatic dollar/gold convertibility, decided unilaterally by the U.S. in 1971, oil became the new standard for the dollar and its sole real backer. Indeed, most oil transactions are made in dollars, and it has become vital for all the economic actors to possess a great quantity of this currency to buy the raw material essential to the functioning of developed countries. The real value of the dollar no longer depends on its equivalent convertibility in gold, but on its capacity to procure a certain quantity of oil. Like gold, oil as an asset has become a good hedge against inflation.
Besides, oil, more than any other raw material, is subject to speculation on financial markets through the use of maturity contracts called futures. Originally, they were uniquely used to provide cover against price fluctuations, a highly coveted insurance by airlines for instance. Nonetheless, they are today the sole object of financial investment from buyers totally separated from the energy and transport sectors. Indeed, future contracts allow the purchase of “dematerialized” oil, which is really convenient for speculators since they do not have to take physical possession of it. The payment is in cash; speculators only cash in the difference between the purchasing price of the matured contract and the cash price.
Therefore, pension funds and hedge funds have without a doubt tried to protect themselves from the fall of the price of the dollar since 2001 by covering their assets with massive investments in oil future contracts. The latter acted as collateral – reserve value – against dollar depreciation. This would explain the explosion of their volumes during this period, the consequence of a totally artificial financial demand for oil, largely superior to the possible physical supply. The result is a market disconnected from reality and a real price explosion between 2001 and 2014, from $40 per barrel to more than $100, capping at $120.
Today, with the new Fed policies, investors are anticipating a dollar rebound, and they distance themselves from oil future contracts. The market, freed from the financial demand, goes back to the fundamentals based on the confrontation between production and real consumption.
Therefore, the market crash we are witnessing could actually be the correction of an inflationist phenomenon generated by the Fed's policy, whose effects could have been multiplied by the use of future contracts.
In a 2012 study, the Organization for Economic Cooperation and Development booked the total assets of the different institutional investors in the world at $78.2 billion. The simple mention of this sum allows us to speculate that a change of investment strategy from these actors can have a considerable effect on raw material prices, even though it is a global market. Beyond political, economic and geostrategic considerations, it is imperative not to neglect the monetary and financial aspects in order to understand the astonishing fall in prices happening currently to the oil market.
The chief argument presented by the mainstream media to explain this phenomenon is the slowing down of the economic situation, notably in China, which entails a downward revision of global consumption in 2015. In addition to global consumption, there is the stabilization of domestic production growth in the U.S., backed by unconventional petroleum products – a stabilization that keeps on tempering U.S. imports. We also hear different geopolitical takes on this story, with Saudi Arabia generally out front as it obstinately refuses – for various reasons – to lower its production. Considering the importance of Saudi Arabia in global production – about 30 percent – its position could force other exporting countries to follow Saudi Arabia’s lead.
Nonetheless, a precise figure analysis invites us to look further down for additional reasons to support these explanations. Indeed, according to the International Energy Agency, global oil production in 2014 was 91.96 billion barrels, and global consumption was 91.44. In 2015, the forecast is 92.75 billion and 93.32 billion respectively. While the gap between production and consumption increases, it is infinitesimal – far from capable of explaining a crash of this magnitude in oil prices, a crash, that is, more than 40 percent.
Yet, if we take a close look at the recent monetary situation, we can see that the fall in oil prices matches the end of QE3, the last of the quantitative easing programs which the Federal Reserve has been implementing since 2008. In fact, Federal Reserve Chairwoman Janet Yellen stopped the injections of liquidity into the banking system last October. In addition, the Fed is now clearly hinting that interest rates will go back up soon.
Quantitative easing and low interest rates simply translate into full-scale money-printing, and were policies implemented to addressing the financial crisis generated by the subprime. As many economists explained it, and notably Peter Schiff, who is known for having predicted the 2008 crisis, this ultra-accommodating strategy has a pernicious effect on the dollar, which loses value as the money supply increases.
Therefore, this change of pace from the Fed reinforces the value of the dollar vis-à-vis others currencies and also raw materials. As we can see, raw materials have lost value vis-à-vis the dollar recently. Nevertheless, it appears oil has suffered a lot more than the others .
This oil overexposure can be explained by its central position in our economies, and also by the way it is handled on financial markets.
Since the end of the automatic dollar/gold convertibility, decided unilaterally by the U.S. in 1971, oil became the new standard for the dollar and its sole real backer. Indeed, most oil transactions are made in dollars, and it has become vital for all the economic actors to possess a great quantity of this currency to buy the raw material essential to the functioning of developed countries. The real value of the dollar no longer depends on its equivalent convertibility in gold, but on its capacity to procure a certain quantity of oil. Like gold, oil as an asset has become a good hedge against inflation.
Besides, oil, more than any other raw material, is subject to speculation on financial markets through the use of maturity contracts called futures. Originally, they were uniquely used to provide cover against price fluctuations, a highly coveted insurance by airlines for instance. Nonetheless, they are today the sole object of financial investment from buyers totally separated from the energy and transport sectors. Indeed, future contracts allow the purchase of “dematerialized” oil, which is really convenient for speculators since they do not have to take physical possession of it. The payment is in cash; speculators only cash in the difference between the purchasing price of the matured contract and the cash price.
Therefore, pension funds and hedge funds have without a doubt tried to protect themselves from the fall of the price of the dollar since 2001 by covering their assets with massive investments in oil future contracts. The latter acted as collateral – reserve value – against dollar depreciation. This would explain the explosion of their volumes during this period, the consequence of a totally artificial financial demand for oil, largely superior to the possible physical supply. The result is a market disconnected from reality and a real price explosion between 2001 and 2014, from $40 per barrel to more than $100, capping at $120.
Today, with the new Fed policies, investors are anticipating a dollar rebound, and they distance themselves from oil future contracts. The market, freed from the financial demand, goes back to the fundamentals based on the confrontation between production and real consumption.
Therefore, the market crash we are witnessing could actually be the correction of an inflationist phenomenon generated by the Fed's policy, whose effects could have been multiplied by the use of future contracts.
In a 2012 study, the Organization for Economic Cooperation and Development booked the total assets of the different institutional investors in the world at $78.2 billion. The simple mention of this sum allows us to speculate that a change of investment strategy from these actors can have a considerable effect on raw material prices, even though it is a global market. Beyond political, economic and geostrategic considerations, it is imperative not to neglect the monetary and financial aspects in order to understand the astonishing fall in prices happening currently to the oil market.
Your theory that an inflated dollar causes oil prices, which are usually traded in dollars, to decrease is exactly backwards. You also got it backwards as regards speculation in the oil market. There has lately been a significant decrease in speculation and that has helped ease oil prices.