March 15, 2008

Crude Oil Prices, Dollars vs. Euros: Is There a Difference?

I had heard that there was an argument over the price of crude oil: Was the price of crude oil going up due to the fall of the US Dollar (meaning, the price of oil was remaining stable in other currencies) or was the price of crude oil prices just going up, regardless of the currency?

I did a quick-and-dirty analysis and found that the answer is a little bit of both. For my analysis, spot oil prices came from the Energy Information Administration (EIA), the statistics division for the U.S. Dept. of Energy; historical exchange rate data I got from Exchange-Rates.org. From there it was a simple matter of taking the EIA data and converting it from U.S. Dollars into Euros. To make matters simpler, I have used data from a very limited length of time, from January 1 through March 11, 2008, a little over two months.

As you can see in the two graphs below (both of which I created on Excel), the spot prices for both West Texas Intermediate (WTI) and Brent Oil in US Dollars and Euros are very tightly bound from January 1st through February 26th (point 38 on both graphs). Up through this point, the correlation coefficient is 0.986 and 0.982, respectively. (A correlation coefficient of 1 means a perfect positive correlation; this is an extremely strong correlation we're talking here.) Then on February 27th, there's a break between the two currencies. The price of oil in Dollars goes down slightly, but the price of oil in Euros goes down much more (for both WTI and Brent). Even though the correlation coefficients get even tighter during this period (February 27 through March 11) - 0.994 and 0.992, respectively - you can see there's an obvious gap between the spot prices for both markets in the two currencies. The price of WTI oil in Dollars has grown by 9.12% since January 1, whereas it's only grown by 4.92% in Euros. (For Brent Oil, the growth rates are 10.1% and 5.8% in Dollars and Euros, respectively.) But this difference only really started back on February 27th.

West Texas Intermediate Spot Prices

Brent Oil Spot Prices

So, now that I've gone all technical on ya, how can I explain this in simpler terms? It's as if two ice skaters were skating together very tightly. From January 1st through February 26th, they're dancing more or less cheek-to-cheek every day. Then on February 27th, the two skaters decide to let go of each other. They're both doing the same moves (even better than before), but now they're moving further and further apart. In that regard, the answer is both: crude oil prices are moving up and it doesn't really matter what currency the price is in. However, that one day, February 27th, the change in the exchange rates has caused the price of crude oil in Dollars to go up by about twice the amount in Euros.

Update: Cross-posted at Daily Kos.

6 comments:

brnaeem said...

AA- JDsg,

Very nice post...I was wondering along the same lines...glad you cleared this point up.

A logical follow-up question to your post would be what happened on or before 2/27 to cause this subtle separation?

Also, I've read more than once that the usage of the dollar as the currency of choice for oil is one of the reasons for its dominance. And if it were ever decoupled from the barrel, it would be a major catastrophe for the US. Any thoughts?

JDsg said...

Wa 'alaikum salaam, Naeem. For your first question, the answer is, "I don't know." It's a good question, but I haven't had the chance to look into it and I'm not sure I will for another day or two at the earliest. (Certainly not now, Milady's calling me to come to bed. ;) )

As for a switch to another currency for the pricing of petroleum, yes, I think that would make for problems with the Dollar, at least in the short-term. Currencies, IMO, are just like any other commodity; there's a demand and supply for them. If Iran, et al, were to persuade enough countries to switch to the Euro for petroleum pricing (the most likely candidate, IMO), then there's going to be a switch away from the Dollar and for the Euro. Because the demand on the Dollar would weaken very significantly, I think we'd find the exchange rate for the dollar would drop precipitously in favor of the Euro.

However, keep in mind that Europe may not want to have the Euro skyrocket in comparison to the Dollar. The Euro is already at an all-time high right now compared to the Dollar; if the switch were made, it would make European exports to the US (or any other country that demanded US dollars) extremely difficult. The price of European imports would be (insha'allah) prohibitively expensive for Americans to buy, which European businesses who export to the US would definitely not like. So, for the time being, I think it's in the EU's best interest, economically, not to push for and maybe even to resist having the switch from the Dollar to the Euro.

amad said...

Jdsg, since i work in the oil industry, I actually did a very similar analysis, with data all the way back to year 2000...

pls email me and i'll send you the charts... my macro professor loved it!

btw, this trend will continue in the next 6-12 months. You can expect dollar to continue weakening against the Euro. Reason? Quite simple actually.

The US Government is expected to continue lowering interest rate (the Fed Rsv target rate). You can see that in the inverted bond yield curve that builds market expectations into it (see http://en.wikipedia.org/wiki/Yield_curve)

In any case, the Euro central bank is planning to hold tight on int rates. It is more concerned about inflation than growth. The US is more concerned about growth at this time than inflation.

When interest rates go up in Europe, and go down in US, people move their deposits/"safe" investments into European banks. That means they sell dollars and buy Euros in order to hold in banks. Demand for US dollars goes up, and price (like any other commodity) goes down.

Right now is not the time to hold dollars or any other dollar-pegged currency (riyal!) and move into Euros.

Since oil is priced in dollars, it will continue to go up, not because of demand and supply dynamics in the oil market, but mostly due to the currency devaluation. In fact, if the dollar had held up with the Euro for the last 5 years, oil would be about $60/bbl.

Hope Jdsg can post the graphs that add to the analysis...

enjoyed it!
w/s

Amad said...

my email

amad said...

"Demand for US dollars goes up, and price (like any other commodity) goes down. "

I meant of course, demand for US dollars goes DOWN, and price goes down

M. Hussain said...

Sallam JD,

Thanks for the article. For me there are a few things playing out that are very significant. The fall of the dollar is definitely one of them. Some others are:

1. The variance between the LIBOR rate and the Fed which has switched so that the Fed rate is now on a premium to the LIBOR.

2. The real price of commodities discounting inflation.

3. The rapid depreciation of the US Dollar over the past 7 years.

4. The collapse of the sub-prime market and the domino effect it has on the US economy.

As for the variance in exchange rates its beyond just interest rate differences but also the higher inflation rate in the US economy which is being hidden by the Fed. this is a result of Bernanke's policy of attempting to revive the US economy by injecting liquidity. It is also perhaps a result of the BOP defecit coming to roost now that the trade deficit is not being compensated by capital inflows to the same extent.

Fundamentally, I believe that the boom post 2001 was engineered by government expenditure expansion, but this has now reached its limit, and being a quick fix has created its own set of problems.. notably the decrreasing efficiency of resource allocation. the PPT which was a conspiracy theory till recently when it was made official has also led to missallocation and harmed the fundamental characteristic of the US economy - ruthless market efficiency; when Longterm capital was bailed out, when (as many believe) the Fed intervened to revive the stock market after 9/11, and when again perhaps it has started doing the same during the present downturn, its changed the very unique characteristic of the US economy - that of free markets and made it more of a managed "free" market.

With continued rampant mismanagement of fiscal and monetary policy, it is likely that the exchange rate will continue to fall, and the increase in exports that Bernanke is hoping for due to the lower exchange rate will never come (why? I think because US companies are facing far higher inflation rates at home than is being reported and US exports typically have not been very price sensitive, and there are too many tough competitors in their main export markets for US companies to win by simply lowering prices, and last but not the least, typically US companies have followed a strategy that has not been cost based so lower prices would put them in a different market segment).