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Forex Q&A with Ed Ponsi - The Oil Question
Hi everyone! I really enjoy answering your questions about Forex and trading, so please keep them coming. This week's article features a multi-faceted question about oil and the U.S. Dollar. Here we go!
Question of the Week
Q) Hi Ed, your articles are always eye openers; at the risk of sounding dumb I'll ask the following. I don't understand why oil prices should rise with a weak dollar. As far as I understand prices are set by supply and demand of the commodity, so where does the dollar fit in? The only reason that comes to mind would be that oil producers like OPEC want to receive the same purchasing power than before and raise the price. From what I hear in the news it's pure speculation from traders causing the rise, not OPEC or the weak dollar. Thanks for your comments.
Ed Ponsi) Thanks for your question, it's a good one! Here's a thought – never feel bad or dumb when it comes to asking questions. In this business, everyone starts out at the same level – at first we know nothing, and the only way to learn is to ask. I can distinctly remember asking question after question of my fellow traders when I got started, and while some of them found it annoying, my attitude was, that's too bad – I was on a mission to learn and nothing was going to stop me!
There are quite a few factors affecting the price of oil, but one of the main factors is the weak U.S. Dollar. Here's why – everywhere in the world, oil is priced in U.S. Dollars. Most Americans think of the U.S. Dollar as having a fixed value, but it doesn't. The greenback has been losing value for years against other currencies, but for many Americans, this does not seem to be important. Many of us have more dollars now than we've ever had before, but today's dollars have less buying power than in years past.
The weak dollar becomes important to us the moment we purchase something that is imported from another country, such as oil. When other countries accept U.S. Dollars as payment for oil, they are accepting a currency that has performed miserably. Here is this decade's performance of the U.S. Dollar Index, which measures the U.S. currency against a basket of currencies that includes the Euro, the Japanese Yen, and the British Pound, among others (see figure 1).
Figure 1: The U.S. Dollar Index falls sharply over the past decade. Source: FX Street
Now imagine that you receive payment for your products or services in a foreign currency that has lost more than 1/3 of its value this decade. That's exactly what has happened to the buck; you can see on the left of the chart that the U.S. Dollar was trading at nearly 120 vs. the basket of currencies back in 2001. Now the greenback is trading at about 74, a loss of more than a third of its value. If one dollar has a current value of 74 (year 2008), you would need 1.62 of today's dollars to equal the value of a 2001 dollar (74 x 1.62 = 119.88, or nearly 120). Therefore, the price of oil would have to rise about 62% (as measured in U.S. Dollars) just for the producer to break even – and this is before we take into account speculation and the supply/demand equation. Because dollars are shrinking in value, the producer needs more of them just to maintain the old margin of profit. This is one reason why some of the world's major oil producers want to move away from the USD and instead accept Euros for payment.
Ok, so we know that the weak dollar is partially to blame, but the price of oil has certainly risen much more than 62% in the past few years. What other factors are driving the price of crude higher?
Are Speculators To Blame?
It's true that the news media has chosen to focus on speculators as a cause of problems in the oil markets. Isn't it funny how speculators are always at fault when something bad happens, but never get any credit when the price goes the other way? When oil fell below $20 per barrel about a decade ago, did anyone say, "Wow, thank goodness those speculators drove the price down"? No, because speculators are convenient scapegoats, they never get credit, only blame. Consider this - if it is true that speculators are causing the price of oil to rise, those traders are going to have to cover their positions and take profits at some point in the future. So if they are pushing the price up, this is only temporary - they will eventually have to push it back down when they sell, unless they plan to hold long positions in oil for months or years. But if that were the case, that would make them long term investors, not speculators.
Leave it to the news media to take the easy way out and place blame without really understanding the situation. But that is the nature of the business; a reporter has to report something, and the story about speculators plays well (Wall Street villains!), and since no specific person or entity has been blamed, there will be no denials. From the reporter's perspective, it's a perfect story.
Supply and Demand
T. Boone Pickens, an energy entrepreneur who is now investing heavily in wind power, put it simply and eloquently. In a recent interview on Bloomberg television. Pickens said the current demand for oil simply outstrips the available supply. According to Pickens, 85 million barrels of oil are available on a daily basis, but the current demand is for 86.4 million barrels per day. He feels that the price will keep rising until it reaches a point that will drive demand down to 85 million; then, the price should stabilize. This simple yet powerful argument assumes that no major additional supply of oil will appear; many believe that the Saudis and the rest of OPEC are already pumping just about all that they can, and it seems unlikely that the vast untapped U.S. oil fields in Alaska and elsewhere will go into production in the foreseeable future. Even if new oil were available, it is questionable whether the U.S. will have the ability to quickly refine it. The U.S. has not built a new oil refinery in over thirty years, and the ones that are still in operation are slowly falling apart.
Where Does It All End?
Loose U.S. monetary policy has brought us to this point, and we have a critical decision to make. We can continue to allow the U.S. currency to erode, which will hasten its decline as overseas investors lose confidence and avoid the dollar at all costs. There are those in the U.S. who actually want a weaker dollar so that exporting companies will sell more products; this is something that Steve Forbes refers to as "Zimbabwe economics". If we continue down this path, the ensuing crash of the USD will be much worse than what we have seen to this point, and could cause the price of oil to double or triple from its current levels, since future dollars will be worth even less - and therefore purchase less oil - than current 2008 dollars.
Or, we can bite the bullet. We can take a stand and say, "no more". Put an end to the U.S. easy-money policy. Stop adding to the money supply. Yes, it will be unpleasant for a while, but the patient is very sick and needs to be cured. Higher interest rates and a stable money supply will make the U.S. currency stronger, which in turn means that fewer dollars will be needed to purchase a barrel of oil. This will not solve the supply/demand side of the equation; that will only happen if high prices destroy demand, or if additional supply becomes available. But if we strengthen the dollar, it will purchase more oil – and more of everything else – that is imported into the United States. Let's hope Bernanke and the Fed are finally getting serious about solving this problem.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ed has appeared on CNBC, CNN International and TheStreet.com, and has recently written his first book for Wiley Finance, "Forex Patterns and Probabilities" (which you can purchase through