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Column: OPEC’s continued failure — A note on the price of oil

Price of oil

The price of oil has fallen in nominal terms and even more in real terms as crude trades in US dollars, which have declined by nearly 7 per cent this year. Shutterstock image.

Global glut, increased US production impact price of oil

By Ed Hirs

No one is fooled by the illusion of OPEC production cuts, but it is worse than most think.

The price of oil, which has fallen in nominal terms during 2017, has fallen even more in real terms, since oil trades in dollars and the trade-weighted value of the dollar has declined by nearly seven percent in 2017.

There is no indication that the price of oil will recover on a nominal dollar basis. Continued high inventories around the world signal that supply still outpaces demand, thwarting any balance that will support higher oil prices. Sluggish global demand growth is one factor. This global economic weakness contributes to the relatively weaker dollar that supports the U.S. economy overall.

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A second factor is more efficient U.S. shale oil production. But in the end, OPEC’s discipline has fallen apart, and they cannot remove the necessary 2.0 million barrels per day of production from the market.

 The data are easy to find. The Federal Reserve Economic Data, or FRED, at the Federal Reserve Bank of St. Louis is a good resource.

On January 4, 2017, the Trade Weighted Value U.S. Dollar Index Broad, stood at 128.5246. By July 26, the index stood at 119.7710. The value of the dollar had fallen by 6.81%. That is, U.S. residents would have to pay 6.81% more than they did in January to buy the same basket of goods and services from China, Europe, Mexico, Canada and South America.

Back on January 4, the price of West Texas Intermediate, or WTI, was $53.26 per barrel. By July 24, the price of WTI was $46.21 per barrel, or down 13.2%.

And for completeness, the FRED data report the price of Brent oil on January 4, was $54.57 a barrel. On July 24, the price of Brent was $47.81 a barrel, or down 12.4%. The price of Brent has ranged higher than WTI in recent years because of massive production declines in the North Sea oilfields.

The price of oil is set globally by supply and demand of oil, and this price is frequently affected by the value of the dollar. Unrecognized moves in the value of the dollar – including the current drop in value – can obscure underlying dynamics of supply and demand in the oil markets. Just like with The Economist’s Big Mac Index, Yale Professor William Nordhaus’ work shows that the price of oil across the world is the same after adjusting for differences in crude grades and transportation costs. That is, Purchasing Power Parity and the Law of One Price hold for oil around the world.

SKYACTIV-XWe can think of oil as a currency itself. Some countries, such as Venezuela, barter oil for other goods and services because they have been excised from the worldwide dollar economy. As the value of the dollar declines, the value of the barrel of oil declines. Venezuela may still be producing approximately 2.0 million barrels per day but its trading partners will not offer the same amount of goods – food, medical supplies, automobiles – as they did earlier in the year.  Why? Because their own currency can buy more goods sold in dollars.

If the crude oil market had the same supply and demand balance in July that it had in January, the July constant dollar price for WTI would be $56.89 per barrel and Brent would be $58.29 per barrel.

Instead, the price of WTI is down by 25.7% on a constant dollar basis, and the price of Brent is down by 18.0%. In this light, OPEC’s failure to maintain supply cuts is even greater than a first glance at price and inventory indicates.

 Because OPEC is paid with dollars that the member nations must convert to other currencies to purchase food, commodities, automobiles, military materiel and other necessities, OPEC members are now absolutely poorer than they were in January.

The more they produce, the more impoverished they become. That conclusion that can also be inferred for US producers.

Ed Hirs teaches energy economics courses to undergraduate and graduate students within the department of economics at the University of Houston. He is also Managing Director for Hillhouse Resources, LLC, an independent E&P company developing onshore conventional oil and gas discoveries on the Texas Gulf Coast.  Previously, Ed was CFO of DJ Resources, Inc., an early leader in the Niobrara Shale. He has authored and co-authored published opinion pieces on energy markets and corporate governance. He founded and co-chairs an annual energy conference at Yale University. 

UH Energy is the University of Houston’s hub for energy education, research and technology incubation, working to shape the energy future and forge new business approaches in the energy industry.

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