Oil is priced in U.S. Dollar (USD or US$); therefore, the oil price becomes strongly linked to fluctuations to the strengths and weaknesses of the USD. The USD is the world’s dominant reserves currency, and changes to its exchange rate are closely linked to the monetary policies of the U.S. Federal Reserve (the Fed in short), and the U.S. fiscal policies.
The Fed has a monopoly for controlling the volume of USD (Federal Reserves Notes, FRN) in global circulation.
In reading this article it is imperative to understand the differences between monetary policies, and the monetary system.
The oil (or energy) system is one or several subsystems embedded in the global financial matrix, and monetary and fiscal policies thus influence the oil’s price formation.
The sequence and interdependence of these activities are.
Changes to total credit/debt ==> Changes to energy consumption ==> Changes to GDP
For all practical purposes, this article documents that these activities in recent decades were perfectly correlated.
- World GDP (PPP) and world energy consumption have been 99% correlated during the last 4 decades, refer also figure 04.
- World economic activity is commonly expressed as changes to Gross Domestic Product (GDP expressed in USD PPP), and in recent decades this has been 98% correlated with changes in world total credit/debt (expressed in USD market value), ref also figure 06.
In short, this means that economic growth (growth in GDP) for several decades has and still is dependent on borrowing from the future (continue growth by taking on more credit/debt) and pull demand forward in time.
As countries, corporations, and households approach debt saturation, growth in credit/debt will slow, which will weaken the so-called credit impulse and economic growth.
Debt saturation; maxed-out balance sheets cannot accommodate more credit/debt. The entity cannot service more credit/debt as additional credit/debt offers diminishing returns with little or no stimulative effect on the economy.
Lowering interest rates allowed for growth in total credit/debt, and gradually a more significant portion of the income becomes allocated to service the growing debts unless income grows as fast or faster.
Figure 1 illustrates the close associations between movements in the oil price with changes in the credit impulse.
I would argue to include public deficits/surpluses when calculating the credit impulse. Public deficit spending adds to aggregate demand.
The high in the oil price during the summer of 2008 happened while the USD was weak.
Towards the end of QE3 in 2014, the USD started to strengthen versus most other currencies (refer also figures 13, 15, and 17).
One significant contributor to the spike in the oil price in 2008 was that investors would rather hold something tangible instead of the rapidly weakening USD, refer also figure 02.
Investors wanting out of their oil positions may partly explain the unprecedented collapse in the oil price of more than USD 100/Bo over a few months in the second half of 2008.
The high investments in U.S. Light Tight Oil (LTO) extraction continued after the collapse in the oil price in 2014 based on expectations of a sustained higher oil price. The effects of a weaker USD and high global credit/debt growth appears poorly recognized.
In 2016 a new round with high global credit/debt growth helped support a renewed increase in the oil price. This credit impulse came to an end during Q1-2018, and the oil price collapsed again in Q3-2018. The USD appreciated (higher DXY) significantly since the end of 2014.
The correlation calculations between the oil price and the DXY for Jan-00 to Sep-20 came out at 0,78.
Oil (and several other commodities) priced in USD has an inverse correlation with the USD index (DXY), and the strength of this correlation is not stable.
In figure 02, and for what it is worth, note that the oil price did not move above USD 100/Bo when the DXY was above 90.
Figure 13 shows that the oil price was high and inversely correlated with (DXY) from Jan-11 to Sep-20 (this is somewhat deceptive and will be documented below in this article).
Many other factors influence the oil price, like supply/demand balances, the ebb and flow of speculative momentums, perceptions of future economic developments, changes to consumers’ affordability, and stock levels.
This article will focus on the associations between the oil price, oil supplies (crude oil and condensates; C+C), and the DXY.
The rapidly growing DXY leading up to the oil price collapse in 2014 was a more dominant factor in the collapse of the oil price than the strong growth in U.S. Light Tight Oil (LTO) extraction followed by the increased supplies from OPEC, refer also figures 13, 15 and 16.
In recent decades there has been an exponential growth in world aggregate credit/debt (see also figure 05), which fueled economic growth that commanded an increase in oil/energy consumption (this includes the rapid growth in so-called renewables like solar and wind).
The growth in global credit/debt and a weaker USD combined with low-interest rates in the U.S. allowed for periods with higher USD denominated oil prices partly funded by an increase in external US Dollar-denominated debt now estimated at around USD 13 Trillion.
The increased borrowing from the future allowed for many improvements in living standards and higher wealth accumulation.Continue reading “The Prices of USD, Oil, and U.S. Fiscal and Monetary Policies”