Oil and Gas Report The Financialization of Oil and Why it No

Longer Works Whytecliff Financial Corp.

By Bradley James Parkes, FCSI, G.I.T.

www.bradleyparkes.com Bradley.parkes@gmail.com

Introduction

Oil is arguably the world’s most important commodity that is traded on financial markets. Water

and air is more important to human existence, however, the former is a locally regulated market

in most instances and the second is an underappreciated global “free” commodity.

Crude oil is hydrocarbon chain produced from the microscopic pores of sedimentary rocks found

buried with in sedimentary basins around the globe. The origins of crude oil has been determined

to be the remnants of plant and organic matter that was buried under sufficient pressure and

temperature, a depth regarded as the oil window, that then migrates and forms reservoirs when

trapped by a cap rock or geologic structure. A number of sequential steps are required for an oil

reservoir to form. Organic deposition, burial and hydrocarbon generation, migration and trapping

with in a reservoir with a suitable sealing layer. Missing a single step or having the steps happen

in the incorrect order eliminates or reduces the potential for a sizable reservoir.

Ever since man began to harness combustion to heat his environment and eventually power

machines the input combusted has gradually increased in energy density, also known as specific

energy. Energy density, which is measured in Joules, and relates to the amount of energy stored

in a volume or mass. Gasoline has roughly three times the energy density of wood and natural

gas is roughly five times that of combusted wood. Uranium, which has a higher specific energy

than gasoline or methane, but is less amenable to personal travel, has the highest specific energy

of known substances, however, it is the portability and the ability to harness gasoline or methane

for personal travel that creates the advantage for hydrocarbons as economic inputs.

Crude oil and natural gas are not only economic inputs, but also financial assets traded on futures

exchanges. Futures exchange markets have been around for centuries in one form or another.

The Dojima Rice Exchange in Osaka, Japan is believed to have originated in the late 1600 and the

Dutch Tulip bubble of the 1630s utilized forward contracts in the later stages of the mania. As

future markets became less regulated and more open in the modern post World War II world an

increasing number of participants have been attracted to the diversification and hedging factors

of owning economic inputs as financial assets. As financial markets became deeper options to

own economic inputs such as crude oil evolved from futures contracts, to options on futures to

ETF, or exchange traded funds. As the products available increased the participants in these

markets expanded from producers of the commodity, referred to as hedgers and speculators, to

pension funds, mutual funds and eventually to retail investors. This increased and expanded

ownership has further enhanced the importance of crude oil as an input to society. There are few

people who do not have some portion of their income, employment or retirement directly

influenced by the pricing of crude oil. Some nations, such as those of the Middle East, have

economies almost entirely based on the export of oil and in an attempt to influence and create

a stable market set up a production quota cartel, known as Organization of Petroleum Exporting

Countries, from now on referred to as OPEC.

OPEC is an odd entity. The members have less in common than one would imagine and act less

coordinated than a successful cartel would. Within advanced industrial nations, the formation of

pricing cartels generally violates some form of anti-trust law or pricing regulation, however, the

tolerance of OPEC has generally been observed by the advanced industrial nations, who are

mostly importers of crude oil. To balance this market power, America negotiated with Saudi

Arabia to price their exports exclusively in the US currency. America, who has been the largest

importer of crude oil for most of the past century, gained a semblance of control of the pricing,

even though the supply determination was outside its power to determine. Notwithstanding this

agreement, there have been instances where the two main parties, America and OPEC, have

conflicted, such as retaliation by the Arab nations for support of Israel during the 1970’s creating

supply shortages in North America and Europe.

The widespread ownership, the cartelization of supply, the monopoly of pricing and importance

as an economic input is why the oil market is such a complex and geopolitically important sector

and why two pages of ink were spilled to introduce this report. The current turmoil in the energy

markets have created a number of conspiracy theories as well as wide differences in opinion of

what is likely to prevail going forward. However, a simple examination of the supply and demand,

the different inputs and factors followed by an application of game theory should make the

future direction and outcome of the current tug of war clear.

Market Variables

The US Dollar

The globally traded crude oil price benchmarks are priced exclusively in US dollars (USD). This not

to say that there are no side agreements between nations, such as China and Russia, to price oil

in other currencies, however, the reference prices are primarily quoted in US dollars. This feature

of the oil market is the result of agreements between the United States and Saudi Arabia

concluded in 1971 and 1973. This gives America some margin of control over the pricing of crude

oil. As the USD increases in value, the price of oil becomes less expensive to American consumers,

but more expensive to foreign nations and when the USD loses value versus other currencies the

price of oil declines for foreign nations while increasing for American consumers. With America

being the largest importer over the past century game theory suggests that America would

maintain a reasonable value for oil imports and not depreciate the vast reserve of dollars the

OPEC nations accumulate through their exports. Whether this is true can be debated amongst

yourselves and would require an extensive report to determine, however, various conspiracy

theories around the relationship suggest it has created an endless demand for USD and has

allowed America to abuse the supposed exorbitant privilege granted to an issuer of a global

reserve currency. For more details on exorbitant privilege one could referee to the works of the

Belgian-American economist Robert Triffin (Triffin Paradox), however, economist Michael Pettis

in Foreign Policy wrote a compelling critique of the consensus view of exorbitant privilege

entitled An Exorbitant Burden. It is not the goal of this report to debate the merits of issuing the

world’s reserve currency, and the author is torn between the two arguments, however to

determine what a USD is one must approach the debate.

To determine what oil is priced in one must figure out what the dollar is. Measure something,

one needs to know the units of the measuring stick and whether the measuring stick is consistent

over time. Under the post-World War II international financial system agreements, known

colloquially as Bretton Woods, the USD was originally defined as weight of gold, originally fixed

at $35 per oz. of gold, or 1/35th an oz. of gold is equivalent to a dollar. However, since the collapse

of the Bretton Woods system the dollar has become a financial asset, in addition to a currency,

and is now obtains its value vs. a basket of currencies. This basket of currencies was a more

diverse collection of currencies prior to the adoption of the Euro by the European Union and now

the USD index (DXY), however, now the DXY is calculated as a geometric mean (with the

associated weighting), relative to:

Euro (EUR), 57.6% weight

Japanese yen (JPY) 13.6% weight

Pound sterling (GBP), 11.9% weight

Canadian dollar (CAD), 9.1% weight

Swedish krona (SEK), 4.2% weight

Swiss franc (CHF) 3.6% weight

As one can see the DXY is primarily the affected by the value of the Euro Currency and a

substantial weakness in the economies of Europe can have a drastic effect on the strength of the

DXY and the pricing of crude oil. Prior to the creation of the Euro, only 37% of the basket of

currencies was tied to the European continent (the five historical European currencies were:

German mark (DEM), 20.8% weight

French franc (FRF), 13.1% weight

Italian lira (ITL), 9.0% weight

Dutch guilder (NLG), 8.3% weight

Belgium franc (BEF), 6.4% weight

This dynamic creates a forecasting dilemma for the energy exporting nations, for a rise or fall in

the price of crude could theoretically be primarily related to an unstable exchange rate between

the USD and the Euro and affect regional demand based on this relationship. An unintended

consequence of this relationship is that when a nation devalues its currency to promote their

export markets, they increase the value energy imports, decreasing the profits to businesses they

are hoping to encourage to hire, limiting the effectiveness of the policy, however, policy

recommendations are beyond the scope of this report, however, the author would be happy to

tell you how to run the world over a beer, if you are buying.

To highlight this complex relationship between the high weighting of the Euro and the value of

the DXY we present a chart of the DXY from after the collapse of Bretton Woods to prior the

formation of the Euro and a chart of the DXY from post Euro adoption to the present date.

To determine the future outlook for the price of oil an analyst must first determine whether the

changing value is due to supply and demand factors of the crude oil market or is it due to the

complex relationship between financial assets (USD, Euro and futures price of crude oil baskets).

DXY Index Pre-Euro Adoption

DXY Index Post-Euro Adoption

Even with just a quick glance at the two charts one can see the drastically different behavior of

the DXY. In the two charts we have highlighted the different action of the dollar with three

colours, yellow for a range bound DXY, green for a declining DXY and red for a rising DXY. In the

post Euro adoption, the overall range of DXY valuation has been smaller (24% range vs. 64%), but

the trend has been primarily for a weaker dollar (16% lower - green), punctuated by short rallies

that peak at the end of recessions (red line). Whereas in the pre-Euro era the value of the DXY

over 20 years was roughly the same (7% lower) and the flight to the dollar in recessions was less

pronounced or non-existent. This suggests the price of crude oil over the 20 year pre-Euro era

was more supply vs. demand driven than in the post Euro adoption era, where it has been

primarily a dollar weakness event.

How does the price of crude react to the DXY changes? The below chart of crude oil priced in USD

shows the different trends with respect to the DXY index. The general price trend of crude oil

follows inversely to the price of the DXY index. This is significant, because with the new

construction of the DXY, being mostly an anti-Euro index, oil has become a derivative of the

European currency.

However, when one views the ratio of West Texas Intermediate (WTI) at Cushing priced in USD

to the price of an oz. of gold priced in USD (unfortunately WTI data only goes back to 1986) you

can see the ratio has been more range bound, depicted by the orange lines and the effect the

declining DXY has had on the price of WTI (purple line). When priced in USD the price of oil has

increased from $15 to the current $100, however, over the 25 year ratio of these two

commodities, the range is substantially smaller, notwithstanding the apparent volatility. The DXY

trends since 1986 have been overlain on the chart in boxes. The red boxes are periods of DXY

strength, where the price of oil should be declining, green are periods of DXY weakness and the

price of oil should be rising and yellow represents DXY stability. Only the green box since 2002

and the red box from 2008-2009 has the WTI/gold ratio reflected this relationship, as gold has

also become a derivative of the Euro. It appears we are in an era where the DXY has much larger

effect on the price of WTI. This is significant because investment decisions are being based the

value of the DXY and not supply and demand.

In fact for much of 2013 and 2014 while the DXY index was stable, the price of oil was stable as

well. We are in an environment where the DXY index has as much influence on the price of crude

as the supply and demand situation.

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West Texas Intermediate/US $ per Oz. Gold

Global Economic Trends

Between 1985 and 2000 (we are ignoring pre-1985 for the oil price data on the STL Fed data site

is only available from 1985 on) global GDP increased from $12 trillion USD to $30 trillion USD or

250%. This is significant because the price of crude oil is stable over that period of time while the

dollar declines from a peak in 1985 (a result of the Plaza Accord) suggesting that oil supply

decisions (and the resulting price) were reacting to demand and not DXY movement.

Since 2000 the global GDP has approximately doubled from $32 trillion to $72 trillion USD.

However, much of that period included a decline in the USD, making foreign growth worth more

in USD terms. During this period of time oil increased 300%, amplified by the weakness in the

DXY. This suggests that since the DXY index became weighted exclusively against the Euro, the

trend in the DXY has influenced oil supply decisions more than oil demand.

The GDP trend seems unlikely to continue in a strong dollar environment, Europe is in recession

and Chinese growth rates declining. This suggests that the price of oil should continue to decline,

but provide little stimulus to the rest of the world.

The interesting point about China, is that Chinese growth rates have declined, however, the net

expansion of Chinese GDP is still approximately the same. While China barely grows at a 7% rate

these days, the contribution to global GDP is as large as it was when the growth rate was north

of 10%. To quote the IMF:

“A bigger but somewhat slower growing China of the future will contribute about as much to global demand as the

smaller but faster growing China of before. This is arithmetic: An economy that is twice as big can grow by ½ as

much and contribute the same to global demand. By the way, China today is more than twice as big as it was a

decade ago.”

http://blog-imfdirect.imf.org/2014/03/26/china-size-matters/

This can be seen in the below pie chart from the IMF article.

What has changed is the composition of commodity consumption. This could be the black swan

the oil market has not priced in. As China transitions from an export driven economy to a

consumption driven economy the composition of economic imports will change. If motor vehicles

become desired over factory output the importation of more crude oil and less coal could be the

result.

The above chart showing growth expectations from the IMF for industrialized countries shows

how growth has declined for all but the Philippines, US, UK and Spain in 2014 vs 2010. Prior to

the American energy revolution this would be a bullish factor for the global crude market but

with American crude imports declining substantially since 2010, this hardly suggests that global

growth and energy demand will be the factor that balances the market. It appears that for the

crude oil market to come to balance it will have to do so through supply or at a lower price that

spurs demand, due to an increase in the value of the USD.

Marginal Barrel of Supply

Commodity markets are priced on the margin. It is the marginal producer and marginal consumer

that moves the market. It is that last buyer who drives the market out of balance to the upside

and that last producer that drives the market out of balance to the downside. To bring the market

back into balance the marginal barrel of production must be eliminated.

In 1998, American political economist Jude Wanniski gave a speech entitled Thinking on the

Margin that included the following metaphor about the effect of the thinking on the margin that

applies here to the last barrel of crude supplied

“Everyone knows about "the straw that broke the camel's back." It is always that "last straw" that causes a change

in the situation, the marginal straw, even though it weighs exactly the same as each of the other 10,000. But it is

one thing to see that change occurs on the margin and quite another to understand that each straw is equally to

blame for the breaking of the camel's back. Very few people think on the margin, but everyone acts on the margin,

which is why it is so hard to see that the electorate, as a whole, understands economics.

To get our meaning, consider the camel again. He does not blame the last straw for breaking his back, but all

10,001. If straws could think, though, each of the first 10,000 would not blame themselves for doing in the camel,

but would blame the last. The last straw, seeing clearly that his addition caused the camel to break down, would

be the only one of the 10,001 to both act and think on the margin. If the straws were replaced by an equivalent

weight contained in one log, which had a single mind, that log would both break the camel's back and understand

that it had caused the event....”

http://www.polyconomics.com/ssu/ssu-980123.htm

Applying this quote to the futures market and economic analysis, the futures price is like the

camel. It does not care which of the barrels of oil broke the price trend for all the barrels weigh

equally. However, to analyse the market in some meaningful way we must think more like the

straws and figure out which barrels broke the “back” of the market.

Monetary Policy

Throughout this report a theme has been we have been in an era where the value of the DXY

index has had an oversized influence on the price crude oil and this has influenced production

and demand decisions. A valid question is how has monetary policy affected the price of crude

oil?

By all accounts the recovery in the United States has been subpar, with investment and

employment recovering at rates slower than previous recessions. The blog Calculated Risk

produced a chart widely known as the “scariest chart ever” depicting the rate of employment

growth in the recovery of this recession vs. previous periods of economic stagnation. As you can

see in the chart below, not only were the job losses larger than previous Post-WW II recessions

the length of time to recover the job loses took approximately twice as long.

This slow job creation lead the Federal Reserve to implement monetary policy in an

unconventional manner, referred to as Quantitative Easing. The definition of QE can be found all

over the internet and will not be discussed here, however, we will quickly state that it was

implemented with the goal of providing extra stimulus to the US economy beyond the incentives

of lowering interests by purchasing bonds and providing liquidity to the economy.

The below chart shows the overlay of monetary base, what the FED expanded during the

different QE programs, and the price of oil. What can be seen in the chart is that there appears

to be a correlation between spikes in the price of oil and a rising monetary base and the recent

downturn in the price of oil coincides with the end of the Quantitative Easing. This fits with the

theme of this report, in that the price of oil has been overly affected by the value of the DXY index

and by monetary policy. This trickled through the energy sector and created an artificial boom in

production and employment.

The next set of charts shows how monetary policy and its effect on price of crude oil has helped

the FED achieve its goal of stimulating the economy and reducing unemployment. The first chart

shows the employment growth of the mining and oil sector vs. the unemployment rate. In the

time frame between the first phase of QE, known as QE1 and the second phase, QE2, the mining

and energy sector started expanding employment and at the same time total unemployment

began to fall.

The next chart shows this in more detail as it depicts the employment growth of five states with

major shale projects vs. 45 other states in America. Until recently, all of the net job growth in the

US economy has taken place in states with shale projects. One can argue that the QE programs

have been successful in achieving the goal of spurring employment in the US economy, as now

the growth seems self sustaining enough that the other 45 states are now about to add net job

growth for the first time since pre-2008. However, this is happening at the time where the net

job expansion in the shale states are starting to decline, and will decline further with the recent

crash in the price of oil. The unintended effect of QE was to break the back of the camel, will this

create a negative feedback loop? It will if American shale production is the marginal barrel.

Effect to the Global

Economy This system worked well while the United States was the largest importer of crude energy.

As the USD weakened, the price in USD would increase, but would become less expensive

for the rest of the world. This would spur demand in the rest of the world and lower costs

of export to the US, which is also the consumer of last resort for the world. As the USD,

strengthened the imports of crude oil to the US would decrease in cost and leave extra

money to purchase extra goods from the rest of the world. Now as the USD is just the

reverse of the Euro it plays the American economy off the European economy and forces

emerging markets to maintain an ever changing basket of reserve currencies. The only

way for the rest of the globe to grow is for a never ending decline in the USD to take hold.

As everyone knows, trades cannot go one way forever.

Now as the US has become closer to being energy independent, as shale production has

increased American crude output, the trade deficit declines and the dollar strengthens,

making crude oil more expensive for the rest of the world, while the US no longer picks

up the slack from extra crude oil supplies on global markets. This series of events leads to

a global crude surplus further weakening the exporting nations, while at the same time

increasing the import cost for emerging markets. This makes global recoveries almost

impossible to be maintained in the US, Eurozone and emerging markets simultaneously.

Conclusions

The relationship that financialized crude oil no longer functions in the manner that made it a

successful system for the past 40 years. This relationship of using the USD to price global crude

oil worked as long as America was the largest importer and the USD was not the inverse of a

single monetary region. Under this system when the DXY, the global measure of the USD rose, oil

became cheaper for the US economy and more oil was imported. The producing nations would

peg their currencies to the USD and the increasing purchasing power of their reserves would

allow increased imports from Europe and Asia, thus providing a boost to their economies. When

the USD weakened, the price of oil would increase in the US economy and decline in the Asian

and European markets and provide cheaper inputs to create the exports that would be purchased

by dollarized economies. This ebb and flow required that oil imports were absorbed by the

reserve currency issuer. The system has begun to break down because America no longer needs

to import as much oil from the producing nations. This crack in the system did not become

apparent until the DXY began to rise in purchasing power.

This time when the DXY index began to rise, the cheaper oil was not absorbed by the US economy,

due to rising production and because the DXY is now an inverse to the Euro, the price of oil in

Euros increases at a time when the EU economy is already weak, creating a further weaknesses.

This is why the Saudi’s first move was to discount the price of Asian oil exports to protect market

share and combat the increase in the DXY. The reserve currency issuer HAS TO BE THE LARGEST

OIL IMPORTER for this system to function smoothly and to create the ebb and flow already

mentioned.

The stronger dollar is causing relative inflation to the weaker nations and the increase in US

domestic production is not absorbing the excess supply. This is why the second part of the OPEC

plan is to kill the marginal barrel in the US.

If OPEC is successful in killing the marginal barrel the ramifications is that there will be a return

to unconventional monetary policy and a delay to energy independence and a return to a price

range of $70-90 USD per barrel of crude. This time the US production response will be slower to

react to the price incentives, because like Mark Twain’s cat who sat on a hot stove and would not

sit on any stove going forward the high yield bond market will be less likely to advance the

required sums to advance the marginal barrel projects.

Looking back on this period of events in the future on thing may become clear, to paraphrase

Mark Twain again, the death of OPEC may have been highly exaggerated and that non-OPEC

energy producers should have adapted to protect their balance sheets against the stronger USD.

Hedging oil revenues in gold, creating an unofficial Bretton Woods system, will become

imperative. This should offer some protection against financial driven swings in the price of crude

oil and eliminate the oversized influence of the DXY on crude oil prices.

Another lesson of hindsight is that investment and production decisions cannot be based solely

on price and cash flow generation, and must rely more on the idea of balance sheet stabilization.

The boom/bust cycle must be dampened by avoiding the desire to be “all in” followed by “all

out”. The final lesson of this era, especially in the light of America’s drive to continue to seek

energy independence, and this lesson can be extended to other financialized commodities, is that

commodities should be priced in a basket of currencies, or even in Special Drawing Receipts (a

ready-made basket of currencies created by the IMF to facilitate international trade). The system

of financializing commodities through the monopoly pricing in a single currency works as long as

the reserve currency issuer is the world’s largest importer, or purchaser of last resort and the

reserve currency value is based on a wide variety of competing currencies and not dominated by

the inversion of a single region. Similar problems have begun to appear in the price of copper

and exist in the gold market.

A failure to head these policy recommendations will continue to create malinvestment in

extractive resources and further amplify the boom bust cycles and impoverish producing nations

at the expense of the reserve currency nation.

References