USD & Oil Prices: Their Weakening Correlation

Table of Content
0.Introduction
0.1.The Traditionally Inverse Relationship
1.Historical Backdrop
2.The Reasons for the Weakening Correlation
2.1.The Shale Gas Revolution
2.2.The US oil production has surged
3.Drivers of Oil Prices
Up
1.Rising consumption
2.US sanctions on Iran
3.Issues Saudi Arabia
Down
1.OPEC members + increased oil production
2.Low Demand Forecast for oil in 2019
3.US oil production and stockpile surge
4.Shale Gas Revolution
4.Unknown Factors
4.1.Saudi and Khashoggi’s killing
4.2.Biggest OPEC Oil Exporter & Arms Importer
4.3.U.S. Shale production and refineries
5.Drivers of USD

0.Introduction

0.1.The Traditionally Inverse Relationship

Historically, oil prices and the US dollar have long had an inverse relationship. The well-established narrative explains that as the US dollar being the world reserve currency, commodity prices including oil contracts are usually settled in US dollars. When the value of USD goes up, it naturally makes oil prices cheaper. Conversely, when the US dollar weakens, it requires more dollars to buy the same quantity of oil, hence it makes oil prices more expensive. As the unit of account rises in value, the oil price denominated in dollars becomes less. This much is fairly simple.

1.Historical Backdrop

Back in 1925, oil accounted for only a fifth of American energy usage, however, by the time WW II broke out, a third of America’s energy demand was met by oil. Oil began to replace coal as a preferred fuel source, and it was used to heat homes and generate electricity, and it was the only fuel that could be used for air transport.

In 1920, American oilfields accounted for nearly two-thirds of global oil production, and in 1945, US oil production had even exceeded the two-third point. During the decade of 1945-1955, the US had been able to meet its own energy needs independently.

By the late 1950s, however, the situation had changed completely, as the US was importing 350 million barrels of oil per year, albeit mostly from Venezuela and Canada then. By 1973, US oil production had fallen to 16.5% of global output, and the country had become a net importer of oil (Painter, 2014). Hence, the negative correlation between oil prices and the US dollar was established.

Over the past years, however, their ordinarily inverse relationship has considerably weakened. The following graphs show the correlations between USD and the crude oil prices for the period of the first oil crisis, 1973-1975, and the more recent period of 2016-2018 (Fig1; Fig.2). The correlation coefficient between USD and crude oil prices for the period between January 1973 and May 1975 was -61% with a 2% standard error, whereas the figure for the more recent period of January 2016 and September 2018 was -5.4% with the standard error of 3.3%. Although numbers vary, depending on which period to sample, it nonetheless shows the considerably weakened negative correlation.

Fig.1January 1973 – May 1975
           USD(DXY) – Series 1
           Crude Oil Prices(Inflation adjusted monthly average) – Series 2
           Source: Mactotrends. LLC. (2010-2018a; 2010-208b)
           Correlation Coefficient: – 0.61, Standard Error: 0.02 (computed by the author)

fig-1_january-1973-may1975-e1540893973331.jpeg

Fig.1January 2016 – September 2018
           USD(DXY) – Series 1
           Crude Oil Prices– Series 2
           Source: Mactotrends. LLC. (2010-2018a; 2010-208b),
           Correlation Coefficient: – 0.054, Standard Error: 0.033 (computed by the author)

fig-2_january-2016-september2018.jpeg

2.The Reasons for the Weakening Correlation

Here, the reason why the negative correlation has been diminishing is that the underlying assumption of the US being the net importer of oil has destabilised in recent years, and there are several reasons.

2.1.The Shale Gas Revolution

The first reason for the weaker correlation between USD and oil prices is the American shale revolution. Head of Goldman Sachs Research Jeffrey Currie says, “in 2008 … the US was importing on a net basis nearly 12 million [barrelsper day] of oil and products. Owing to shale technology,
today, that number is less than 5 million b/d. And subtracting out Canada and Mexico, the number drops to 2.4 million b/d. In other words, net imports are over 60% lower than in 2008.” (Holodny, 2014) (Fig.3) Currie’s comment is fairly consistent with the calculation presented above (Fig.1; Fig.2).

Fig. 3: Correlations of Daily Returns vs. Oil Trade Balance (Quarterly Data)
            Source: BEA, EIA, Goldman Sachs Global Investment Research

Fig.3_Correlations of Daily Returns vs Oil

Currie (2018)claims that the “stronger-than-expected” demand for oil was driven by the shift from a “lower-for-longer” to a “higher-for-now” oil price environment.

Moreover, the bullish trend over the summer was due to growing global demand driven by the “faster than anticipated” rebalancing of global inventories, speculation over supply disruptions among key OPEC producers, most notably Iran due to the US sanctions, and constraints in the American shale production, rising trade tensions, and shrinking global inventories (Goldman Sachs, 2018a). To illustrate that, in July, Gasoline stocks USOILG=ECI fell by 3.2 million barrels, whilst distillate stockpiles USOILD=ECI that include diesel and heating oil dropped by 371,000 barrels (Gaffen & Mersie, 2018).

That being said, in the long run, the “new oil order” brought by the shale revolution is expected to keep prices anchored (Goldman Sachs, 2018b).

2.2.The US oil production has surged

As Trump broke off the Paris Agreement immediately after he entered the Oval Office. Since then, oil and coal production in the US has dramatically intensified, and in fact, demand for coal increased for the first time in four years in 2017 (The Economist, 2018). Surely, this has relieved the pressure off its reliance on imported oil.

In July, it was reported that the US crude oil production reached over 11 million bpd for the first time, thanks to the rapidly rising shale drilling (Gaffen & Mersie, 2018) (Fig.4).

The number of oil-drilling rigs across the country has gone up by about 100 since January (Sell, 2018). More specifically, the number of Baker Hughes crude oil rigs reached 875 on October 26, while the all time high of 1609 was reached in October 2014 (Trading Economics, 2018b).

Fig.4US Crude Oil Production: July 2013 – July 2018
           Source: TradingEconomics.com / U.S. Energy Information Administration

US Crude Oil Production

Table 1: Crude Oil Production by Country
               Source: TradingEconomics.com
Country LastBBL/D/1K (Monthly) Date PreviousBBL/D/1K (Monthly)
United States 10964.00 July 18 10674
Russia 10814.00 July 18 10663
Saudi Arabia 10502.00 September 18 10412
Canada 3783.00 July 18 4123
China 3732.00 July 18 3857 

3.Drivers of Oil Prices

The following rough breakdowns of what is driving oil prices at the moment and USD show their divergent variables (Diagram 1; Diagram 2). First, several drivers of oil prices both upside and downside are discussed.

Up

1. Rising consumption

In the face of rising production, the unchanging fact is that the United States still remains as the world’s top oil consumer. As such, it inevitably depends on imports, and net US crude imports USOICI=ECI grew to around 9 million bpd by 2.2 million bpd (Gaffen & Mersie, 2018).

2. US sanctions on Iran

The effect of the sanctions in regard to oil is expected to be the withdrawal of oil from the market as much as 2 million barrels a day, equivalent to 2% of world supplies (Sheppard, 2018). The US sanctions on Iran will come into effect on 5 November, and it may again steer the current bearish market sentiment with oil back into an upward trend.

3. Issues Saudi Arabia

The ambivalent relationship between the US and Saudi Arabia was mostly triggered by the suspected killing of the influential dissent journalist Jamal Khashoggi, who used to write for The Washington Post as a contributing columnist (Hubbard & Kirkpatrick, 2018). During his voluntary exile, Khashoggi became resident in Virginia and his children are US-Saudi dual citizens. He was a critic of Saudi Crown Prince Mohammed bin Salman and, allegedly, had long been on the radar of Saudi intelligence agencies. The Turkish government recently released a new piece of evidence, suggesting that the killing was premeditated by Saudi Intelligence, implying the prince’s involvement.

Saudi Arabia is the biggest exporter of oil while it is also the world’s largest arms importer along with India, and the US is heavily reliant on Saudi’s buying of military weapons from the US (DeYoung et al., 2018). Germany has already expressed its intention to bring to a halt its arms exports to Saudi, however, the US, together with the UK and France, will likely remain reluctant to cease its arms export, which will risk hundreds, if not thousands, of jobs domestically.

Table2World’s Arms Exporters in the post-war era
               Source: SIPRI Yearbook 2013
1950-2017 Supplier Arms Export in billion, trend-indicator values
1 United States 673,010
2 Russia 588,150
3 United Kingdom 140,380
4 France 120,700
5 Germany 85,980

Down

1.OPEC members + increased oil production

In response to rising oil prices during the summer, the president Trump urged the OPEC + countries to ramp up their production. Since then, OPEC members, such as Saudi Arabia and Libya have increased oil outputs (DiChristopher, 2018).

2.Low Demand Forecast for oil in 2019

Expected growth in supply from U.S. shale producers led the OPEC to lower its forecast for the global demand for its crude in the coming year (Sell, 2018; DiChristopher, 2018).

3.US oil production and stockpile surge

In October, crude stockpiles in the U.S. have risen for four straight weeks, which was the longest run of gains since early 2017, which increasingly eases the future demand (Cho & Smith, 2018).

4.Shale Gas Revolution

In October, the US official agency reported that shale oil production is expected to reach a new all-time high in November, which will ease an upward pressure on oil prices (Sell, 2018).

diagram-1.jpeg

4.Unknown Factors

4.1.Saudi and Khashoggi’s killing

As mentioned above, the relationship between the US and Saudi Arabia has become an ambivalent one, in particular, over the killing of the journalist Jamal Khashoggi. It has recently surfaced that a group of Saudi agents was involved in the killing, beating the fugitive to death and his body was brutally dismembered. While the investigation continues, if Saudi agents were found to be the culprit definitively, the congress, if not the president Trump, may take some form of retribution, as the public sentiment grows (DeYoung et al., 2018).

4.2.Biggest OPEC Oil Exporter & Arms Importer

That said, being the biggest OPEC oil producer, knowingly, Saudi has been bumping up its production, and this “oil” card is left at its disposal to deter the US administration from making any bold move in dealing with the murder. Be that as it may, Saudi Arabia is very unlikely to use the oil market as a means for retaliation, as constraining exports would be a blow to its carefully constructed international reputation as a trustworthy supplier (Cho & Smith, 2018).

Currently, Saudi’s increasing oil production is putting a downward pressure on oil prices. Despite that, depending on how the investigation will turn out and the international community together with the president Trump will deal with the situation regarding Khashoggi, the bearish trend may pivot.

4.3.U.S. Shale production and refineries

Although the US output growth in shale crude seems promising, the US refineries are not ready to process much of the domestically produced crude. Most refineries in the US are configured for heavier grades, such as the ones from the Persian Gulf, particularly Saudi Arabia (Sell, 2018). There has been a concern over the relevant infrastructure to bring oil to market, which may cause a bottleneck situation (Gaffen & Mersie, 2018). This is another reason that the role of Saudi in oil prices remains critical.

5.Drivers of USD

In the meantime, the identifiable drivers of USD are perhaps mainly the following.

1. The Fed’s inflation hikes driven by strong US economic data

Despite the recent “near-correction” tumbling in the equity market, the Fed may continue the current gradual approach to normalising interest rates. They see the neutral interest rate being 3% as discussed in their recent meeting (Condon, 2018).

2. More investors buy USD

3. USD appreciates against other currencies

4. Dollar-denominated debts in emerging markets inflate

5. Investors seek safe heavens in USD (Rose, 2018)

6. Strengthening of USD accelerates

Drivers of USD

 

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