After The Fall: A Long View On The Link Between Oil And The U.S. Dollar

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Includes: OIL, UUP
by: Evariste Lefeuvre
Summary

Huge price swings in both the U.S. dollar and oil prices have led many analysts to look for historical references.

The mid-1990s could be a good starting point but by many aspects, the mid-1980s also look like a good candidate..until the U.S. dollar is taken into account.

On many aspects, the “reverse oil shock” of 1986 can provide some clues in understanding today’s moves in oil prices.

As I show, the relative behavior of oil and the U.S. dollar is completely different this time.

Huge price swings in both the U.S. dollar and oil prices have led many analysts to look for historical references. The mid-1990s could be a good starting point since the dollar rose while oil prices fell. The U.S. economy was in mid-cycle and the Fed was ahead in its tightening cycle while the Mexican crisis of 1994 highlighted the sensitivity of emerging countries to U.S. long term yields (seen as a proxy of global liquidity).

By many aspects, the mid-1980 also look like a good candidate… until the U.S. dollar is taken into account. The reasons why today's situation may look like the mid-1980s are plentiful:

1. In the years that led to the 1986 price collapse:

a. Saudi Arabia artificially limited - but could not impede - the fall in oil prices, cutting its production by almost three quarters between 1981 and 1985 (from 10 to 3 mb/d when global oil production only edged up by 1Mb/d). In 1986, after several years of unsuccessful attempts to force OPEC partners to observe their production quotas, the Kingdom decided to increase production sharply, abandoning the policy carried out since 1981 to bring oil production back to 7mb/d in 1990. This retaliation against the cartel's "free riders" triggered what is generally called the "reverse oil shock".

b. Meanwhile, long lasting high oil prices had led to:

i. An increase in supply: the exploitation of Alaska and North Sea Oil fields (they were discovered in the 60s but extraction was too costly up to the mid-70s) as well as those of the Gulf of Mexico was made feasible thanks to the OPEC policy. When Saudi Arabia changed its policy, this led to a long lasting supply glut.

ii. Oil-saving measures that led to a fall in demand in many developed economies: between 1975 and 1985, the energy consumption per real dollar of GDP fell from 13.58% to 10.06% (it only edged down to 9.43% in the five years that followed, as lower oil prices reduced the incentive to save energy).

iii. Lastly, the shock dealt a blow on many U.S. producing states with a sharp decline in local job markets. The chart below, drawn from a paper, shows that those states entered a recession independently from the rest of the nation (ex post probability of being in recession for states members of the "cluster). There was no spillover on the rest of the economy.

2. In the years that led to the recent price collapse:

a. Saudi Arabia was behaving as a swing producer to maintain oil prices at a level that was consistent with the budgetary breakeven prices of most of oil producers. The underlying assumption of the so-called "call on OPEC" was that SA would adjust its production to maintain oil prices to a level consistent with each countries' "fiscal breakeven": the level of oil prices required to balance the budget. In late 2014, Saudi Arabia changed its focus. The regime switch was significant and surprising enough to trigger a sharp fall in oil prices.

In a sense, the focus on break-even Brent prices (i.e. price level required for oil producers to balance their budget) hid the growing supply / demand imbalance attributable to the sharp rise in U.S. (North America) production.

b. Meanwhile

i. High oil prices - and this idea that they would remain high for a while - spurred investment in initially costly tight oil / tar sands extraction business. The subsequent fall in the price of capital and the associated easy access to financing (HY debt), participated to the sharp increase in U.S. production (doubling from 2005 to 2014).

ii. A glimpse at the chart below shows that EM economies suffered in the mid-1980 before they entered a multi-decade "catch up" period in the mid-1990s. We may find ourselves in a similar situation given that many EM economies are facing a structural "middle-income" trap: countries with an aging population, a high level of investment (lower return of capita already visible in the fall of average payout ratios in EM stock markets) and an undervalued currency have a high likelihood of decelerating significantly. The dearth of credit linked to rising defaults and the necessity to deepen financial markets can also be a hurdle in the medium run. Absent a difficult repositioning in the value-added chain and higher level of education, the next half decade could witness a significant deceleration of EM growth.

iii. The shock has been felt significantly locally. It is too early to tell whether the oil shock will be isolated and not impact the whole economy, but the contribution of the Mining/oil states to recent U.S. growth, would call for caution.

The chart below sums up the similarities (I don't take into account geo-political factors here). In both cases, the collapse (1) followed a long lasting period of stable or slowly declining prices during which (2) new fields/extraction techniques were implemented. It was triggered by (3) a regime switch in the policy of the "marginal producer" and followed by a long lasting period of low prices.

Real prices of oil tell the same story: a forthcoming long lasting period of low oil prices.

This historical comparison, and the conclusion drawn thereof, may face several challenges.

1. Excess Capacities. Even though there is some significant uncertainties regarding excess capacities in non-OPEC countries, the aggregate level of spare capacities appears much lower today than it was in the mid-1980s. This suggests that the sensitivity of oil prices to a rebound in global growth (EM, Europe) might be slightly higher.

This might be confirmed by the fact that the current level of stocks (OECD perspective) is much lower than it was at the time. The recent rise in inventories is dwarfed by that of 2009 for instance. Changes in inventories had been much more aggressive during that period than recently (on that point, there is still a huge uncertainty on global inventory buildups as well as capacities in ex-OECD areas).

There are some uncertainties yet, linked to Strategic Petroleum Reserves (China's opportunistic buying), EM inventories and , finally, to tankers and Contango-associated buying. This piling up of oil is not the result of supply/demand mismatch but rather "voluntary" accumulation. The Upside appears limited though.

2. U.S. dollar. Interestingly enough though, there is a stark difference between now and then when it comes to the relative behavior of the U.S. Dollar and oil. As can be seen below, the early-2015 rally in the USD has been one of the most violent of the last four decades (scale is inverted). But there is more.

Throughout the early 1980s, the sharp appreciation of the U.S. currency had only a limited impact on oil prices: both series were in negative territories but huge swings in the external value of the dollar did not lead to similar moves in oil prices. The sharp reduction in oil production in Saudi Arabia can only partially explain this muted move by oil.

Moreover, in 1986, oil prices collapsed concurrently with a sharp depreciation of the dollar. The later was propped up by the September 1985 Plaza Agreement, when the governors of the central banks of the G5 met to bring down the dollar. It took more than one year for oil and dollar to move in sync again.

This is in stark contrast with today's situation. As can be seen above, oil prices and the U.S. dollar have moved almost one for (minus) one. There are several possible explanations:

1. In 1986, the "assetification" of commodity and oil prices had not started and FX and commodity markets were still highly fragmented. As can be seen below, the correlation regime between oil and the USD was very unstable.

2. The structural "nature" of the negative correlation between oil and the USD is a new phenomenon. Interestingly enough it seems to strengthen when the U.S. dollar is moving in a range. The interaction between markets might be such today that the correlation would even resist a long lasting upward trend in the USD. For that reason, the strength of the USD will put a lid on oil prices, a factor that did not play out in the mid 1980's.

3. In 1986, the weakening of the U.S. dollar was not market-driven but rather coordinated by G5 central banks while the Fed was easing monetary policy. On the contrary, the Fed is about to raise rates in the second half of 2015. In spite of outcries about the "currency wars" over the last few years, no significant endeavor has been launched to stabilize the FX market.

Bottom Line: On many aspects, the "reverse oil shock" of 1986 can provide some clues in understanding today's moves in oil prices: role of OPEC/Saudi Arabia, supply reaction to a long lasting period of high prices and a sudden strategy shift by the marginal producer. They were all paving the way to several years of low oil prices.

There are some stark differences though that can be summarized in the table below:

Interestingly enough, the relative behavior of oil and the U.S. dollar is completely different this time. While the dollar weakened sharply in the wake of the fall in oil prices in 1986, today's price action is opposite: lower oil prices and a stronger dollar.

It all suggests that a comparison with 1986 can barely be useful to assess medium run prospects for oil prices:

1. Even if pre-shock supply (strong) and demand (weak) trends share the same pattern over the two periods, excess capacities were much higher then, which may change the behavior of price when demand rebounds;

2. The reaction of demand to oil prices might be more muted in advanced economies while uncertainty remains in EM's consumption reaction;

3. Spillover beyond oil producing states might be stronger this time as shown by investment spending in Q1 in the USD;

4. Lastly, it gives no clue on potential global spillovers: there is no coordination this time (Plaza Agreement), the Fed is about to tighten (not ease), emerging countries have suffered a sharp slowdown recently but the external position is much more robust.

But the biggest lesson, to me, could be summarized in one chart: Saudi Arabia cannot afford a 20-year long decline in GDP per capita. Hence a long lasting structural shift from "calling on OPEC" to revenue maximization. The "lesson" is not so much 1986 than the long lasting 1980/85 period during which a combination of lower volumes and lower prices led to an impoverishment of Saudi Arabia.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.