Factors behind spiralling oil price

Arun Chaubey

Against conventional economic wisdom, it is the weak US dollar that is reported to be the main reason behind oil prices rising to record levels, not demand or supply factors. The steady rise in crude oil prices has turned the spotlight on the Organization of the Petroleum Exporting Countries (OPEC), which for months insisted it had no control over the factors that are pushing up the price of oil, including speculation.

Since the dollar is hitting record lows, oil and gas prices are hitting record highs. The limp dollar has prompted a bicker fest between President Bush, who`s been urging the OPEC oil nations to produce more crude to reduce oil prices, and OPEC leaders, who say the problem isn`t limited production, but the weak dollar and economic woes in the United States.

As the US economy has been weakening, interest rates have been falling, and when interest rates fall, investors want to hold less of that currency, because they can get a higher return elsewhere. The price of the dollar is falling, vis-à-vis other currencies. So, one pays less in Euros, for instance, to get a dollar.

As the price of the dollar is same as the value, when the value falls, there`s less demand for it. But a bigger reason for the falling dollar is that the US is running a massive current account deficit, which is being funded by borrowing from the rest of the world. The borrowing is at low rates, but it can`t go on forever. A falling dollar is an automatic adjustment mechanism, which means there`s an increase in exports from the US and lower imports into the country, which helps rebalance the deficit.

In the face of weaker economic growth, the Federal Reserve usually lowers interest rates—one of the things that lowers the value of the dollar.

So, how does a falling dollar contribute to rising oil prices? Oil is priced in dollars in the world market. When the dollar is weaker, foreign currencies are stronger. That means people in other countries can buy more oil for the same amount of money. So we assume oil is USD100 per barrel, and USD100 is equal to 70 Euros. If the Euro appreciates against the dollar by 10 percent, then instead of 70 Euros it will take only 63 Euros to buy one barrel of oil. This way, oil becomes cheaper to foreigners, and they can buy more.

As people in other countries buy more, demand rises, and it drives up the price in dollars, which, again, is how the price of oil is denominated in world markets. So in the United States it looks like the price is going up sharply, in dollars, while in other countries it`s actually going up by much less or staying about the same.

The other important currencies, in this equation are the Euro, the Canadian dollar, and some of the Asian currencies, such as the Chinese Yuan and the Japanese Yen, although the Asian currencies have strengthened less against the dollar.

Oil effect on inflation

As people become more worried about inflation, they are investing more in commodities in general, including oil. And that also drives up demand and prices. So concern about inflation is indirectly driving up the cost of oil, which in turn is contributing to inflation.

It may seem ironic, but this is as important as other factors driving up the price of oil— rising growth in parts of the world such as China and India.

In countries, like India, China, Indonesia, and some Arab countries, the price of oil and gasoline is subsidised, to keep the domestic price low. That matters because if oil prices were allowed to be set at market prices, demand would fall, and so would prices. So demand in those places is artificially high.


Why oil isn’t coming down?

Analysts believe that instead of nervously waiting for oil prices to fall, people will have to get used to these lofty values for oil and other energy products. MarketBeat takes a look at the primary drivers behind this:

Capacity: The oil-producing giants, such as Saudi Arabia and Iran, are pumping about as much oil per day as they possibly can — spare capacity is barely a couple of million barrels, and demand continues to outstrip this supply. Not for nothing was it that Petrobras, the Brazilian oil giant, rallied 8% on news of a discovery despite only vague details about the oil field.

Heating oil: It seems strange, but while gasoline tends to be the chief catalyst for the pre-summer rally in crude oil, heating oil has asserted itself as a major factor. That’s because of increased demand for distillates such as ultra-low-sulfur diesel. Such products, along with jet fuel, impact the trading in heating oil.

Speculation: Large speculators still hold substantial long positions in crude oil, natural gas and heating oil, according to the weekly data from the Commodity Futures Trading Commission, and buying from funds has remained healthy.

Gasoline: The Energy Information Administration has noted that gasoline demand is sluggish in the US, but that doesn’t extend to the rest of the world. The expectation is for reduced driving in the US this summer, but for now, that’s only a forecast, and the price of gasoline remains extraordinarily high.