Friday, March 7, 2008

At $105 Per Barrel, Is Oil Overpriced? It All Depends.

The price of crude oil closed at $105 yesterday, a record new high. As the price of oil continue to climb, people are questioning if the price of oil will continue to rise. Already traders are betting on the price of oil reaching $125 by December 2008, as evidenced by the recent options market activity.

While there are groups of economist and financial managers publicly stating that the price of oil is already too high, that may not be the situation.

Risk of Thinking Inside The Box (i.e., only considering the price of oil in U.S. $)
Since February 2002, the U.S. dollar has declined 76% against the Euro. The dollars to Euro exchange rate on February 1, 2002 was $0.859 to 1 Euro. As of Wednesday, this exchange rate was $1.512 to 1 Euro. Given that oil is priced in dollars, the falling dollar is also a major factor to consider when determining if the price of oil is too high.

Source: LA Times

When one considers the price of oil in Euros, the price of oil has risen much less than when considered in dollars. In February 2002, the price of oil was $18.88 per barrel (or € 21.69, based on €1.149, 28-day average exchange rate). Converting the closing price of $105 to Euros, equates to € 69.44, based on conversion of $1.512 per €1. So the increase in U.S. dollars from $18.88 to $105 is a whopping 456% price increase in five years. However, when calculated in Euro, the price of oil rose by 220% during the same period. While this too is a large increase, it is much less than currently reported in the media.

So, it is only logical for the Saudi Oil Minister and other members of OPEC to consider moving away from the dollar peg and adding Euro pricing.

The Risk of Pricing of Oil in Euros
If the dollar continues to fall in value versus major currencies such as Euro, Yen, and Pound, it will have dire consequences for the U.S. economy. if OPEC begins pricing oil in Euro, we will see spikes in gas, oil distillate, and manufacturing prices in the U.S. Given that the U.S. economy is in a recession and may face slipping into a depression, this is a possibility that we should take into account. Should the U.S. slip into a depression, the Fed would have to continue lowering the Fed rate, perhaps down to 1% or even match Japan’s 0.5%. If that occurs, the falling value of the dollar against other currencies would accelerate.

The Risk of Assuming that Dollar is Still Global Standard
Not too long ago, the global currency was the British Pound. This Pound Sterling standard began to lose its luster shortly after World War II, beginning with the Bretton Woods system of monetary management. In the 1970’s the global currency began to drift toward the U.S. dollar. While we in the U.S. still believe that the U.S. dollar is the global standard, a recent study on the Euro versus the Dollar by David Cobham of Heriot-Watt University, Edinburgh seems to indicate otherwise. In his draft report dated May 2007, Professor Cobham concludes

“…more countries anchor consistently to the euro than to the dollar; this is not because more countries than expected anchor to the euro, but because less countries than expected anchor consistently to the dollar.”

If Professor Cobham’s study is correct, then it is not too long before OPEC begins pricing oil in Euros.

The Long Term Risk of Rising Oil Price and Pricing of Oil in Euro
If the geo-political instability in oil producing regions and the War in Iraq continue, the potentiality of the price of oil will continue to increase. Additionally, this will have a direct affect on the prices of gasoline and oil distillate. It would not be long before the price of gas will reach and perhaps go above $4 per gallon by 4Q 2008 and even begin approaching $5 per gallon by early 2009. As trucks move majority of raw and finished materials in the U.S., this will also cause inflationary pressures on price of all products. In a word: stagflation. The repercussion of price inflation coupled with weakening economy will lead to a vicious downward spiral culminating in a severe depression not seen since the Great Depression of 1930’s.

May your trading be profitable.

Ed Kim

DISCLOSURE: The author holds long positions in Oil Refining Companies at this time

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1 comment:

kiran said...

The price for a barrel of crude oil should be in euros, not in dollars.
That should ease thing down in the financial markets.
The EU already seems to do so at