Oil’s breakout an aid to world growth, but a quandary for Opec

Despite growing political and security concern in the Middle East, the oil market has softened dramatically recently. Perceptions have grown that Saudi Arabia is now as much interested in retaining market share as driving prices higher again in this environment. If so, that’s a downbeat influence in itself for the policy’s duration.

Consequently, the region’s energy-based earnings are diminishing, unless and until a rebound occurs in the winter season, and/or Opec decides at its late November meeting to seek output cuts as a remedy. Yet, a distinctly sluggish world economy appears the greater issue, and it may take a period of lower prices to help secure a revival there.

Ironically, Western policymakers are even worried that the boost to real income that they should welcome in this regard is of lesser importance than the disinflationary effect, i.e. deflating price indexes, which is taken somehow to be regrettable in a world awash with debt that needs working out. More on that another day.

It has already been reflected upon here that the Gulf is caught in the countervailing crosswinds of a rising US dollar on the one hand and falling oil prices on the other, which are offsetting factors in terms of the accruing international purchasing power of hydrocarbon export receipts.

Both trends have attained some momentum, and to some degree interact. As often cited in market reports these days, dollar strength translates into weakening in the call for crude from non-dollar blocs, given the relative expense then of imports.

To what extent is that phenomenon of counterpart variables a given, though? Does it effectively mean that oil prices should be viewed in some underlying sense, by way of a currency basket, to assess the position of supply and demand? And what does history show on the inverse correlation of oil and dollar?

Fawad Razaqzada, technical analyst at Forex.com, told me last week that the relationship was imperfect and has anyway fractured in the past few days. Moreover, the idea of the dollar’s correlation with commodities is better seen in the price of gold.

Equally, though, what relationship there is between the greenback and oil “is not likely to end”, he advised, owing to the denomination of oil contracts. In fact, if the dollar is rising because of US economic strength, as reflected in interest-rate prospects, then the world economy as a whole is liable to be growing faster, and the higher demand for oil implied would put it on the same kind of trajectory as the currency, albeit not necessarily at the same pace.

Hypothetically, it would be reasonable to suppose, though, that US economic growth might respond well to declining oil prices themselves, by way of the impact on real incomes with a reduced fuel bill. Since oil demand could then be anticipated to react because of stronger activity, there inevitably is a slightly circular feedback process in play, and an issue purely of timing in accounting for correlation.

Market reality

As to the current situation, that’s somewhat simpler, it seems. It is the “excessive supply of crude” that is clearly spooking the market, Razaqzada suggests, and the demand outlook “does not look bright either”, with the Eurozone especially struggling to achieve growth, and ominously now even Germany flirting with recession.

That’s the market reality at present, coloured as it is by a conflagration in the Middle East that has not induced an obvious risk premium to prices — which instead show some evidence of discounting amid a scramble to offload production around the world, now that surging US output is having its ripple effect. The impact of that structural shift is having, incidentally, its own impact on the dollar by tipping the balance of payments in America’s favour.

Thus, there’s a slump in the oil price outlook. Barclays, for instance, last week sharply revised its projections for Brent in the fourth quarter and 2015 to $93 and $96 (Dh341 and Dh352) respectively, from the previous forecasts of $106 and $107.

Where oil prices are in terms of a currency basket, without the dollar’s independent influence, is academic by comparison.

For the record, though, when priced in global terms, things don’t look so different historically (see chart). Taking data at annual intervals, only the visual impression of the respective currency denominations of oil stands out, namely that the dollar-based series appears more exaggerated. However, in percentage terms relative to scale, the movements shown are broadly much the same, whether viewing prices in euros or the IMF’s established basket of so-called special drawing rights (SDRs, a weighted average of the four leading international units, adding the Japanese yen and UK pound sterling to the mix).

Hence, the message from the numbers doesn’t change. Oil prices are under pressure in a way not seen for a while, introducing a fascinating factor to world economic scenarios, and creating further drama ahead of the next Opec meeting.