Historical Analysis of Real Global Price of Oil: Implications for Future Prices*
William D. DeMis1
Search and Discovery Article #70037 (2007)
Posted December 3, 2007
*Minor adaptation of presentation in 2000 by the author at AAPG Annual Convention, New Orleans, Louisiana, 2000, for which he received the Best Paper Award, Energy Minerals Division. He presented an earlier version at the AAPG Annual Convention, San Diego, California, 1996, for which he received Best Paper Award, Division of Professional Affairs.
1Marathon Oil Co, Houston, TX (retired) ([email protected])
[for 2007 Online Presentation]
Today, oil prices are at record highs and the value of the US dollar on global currency markets is reaching historic lows. Some analysts have suggested a connection. This paper shows that throughout OPEC’s history, OPEC has frequently offset a low US dollar by raising nominal prices to maintain purchasing power parity.
The key concepts of this paper were first presented at the AAPG national meeting in 1996 in San Diego. An updated version of this paper was presented at the AAPG national meeting in 2000 in New Orleans. This is the original 2000 presentation, preceded by the abstract for it. Word slides and annotations on the graphs have been added to clarify spoken points, taken verbatim from my notes.
[for 2000 Presentation]
Traditional analyses of oil prices show a “constant price” corrected using the U.S. consumer Price Index. The Real Global Price of oil is the price corrected for inflation and for fluctuations in the U.S. dollar’s value relative to a weighted basket of currencies. The Real Global Price of oil is a more accurate measure of oil’s value on global markets over the past 30 years.
Since the U.S. abandoned the Bretton Woods agreement in 1971, the value of the U.S. dollar has varied sharply on global markets; gaining or losing as much as 35%. OPEC countries obtain 80-90% of their revenue from oil sales that are priced in U.S. dollars. Changes in the U.S. dollar’s value can affect OPEC’s purchasing power, almost as much as changes in nominal prices.
When the value of the U.S. dollar drops and the Real Global Price falls, as happened in 1973, 1979, and 1995, OPEC has reacted with supply cuts, price increases, and/or calls to abandon the U.S. dollar as the basis for pricing oil. In June, 1995, the U.S. dollar sank to all-time lows. OPEC ministers openly called for abandoning the U.S. dollar. Oil price increases followed. Recent oil price lows of 1997-98 were not sustainable because the Real Global Price of oil fell below the previous all-time low set in 1973. OPEC countries are now dependent on oil revenues to fund large social programs and a growing middle class – expenses that did not exist in 1973. (The opinions herein are solely the author's and do not reflect Marathon Oil Company's opinions).
The Real Global Price of oil is the price of oil corrected for inflation and for exchange-rate fluctuations of the U.S. dollar on global currency markets. Exchange rates, and the Real Global Price of oil, are important because OPEC sells oil for U.S. dollars and then uses those dollars to buy German pharmaceuticals and Japanese cars.
So, for example, if the U.S. dollar falls 20% relative to the German mark, then the price of those German pharmaceuticals goes up by 20%. OPEC can, and has in the past, lost purchasing power by virtue of an eroding dollar and responded with higher prices.
OPEC countries, excluding Indonesia, get 75 to 90% of their income from the sale of oil. Changes in the value of the dollar have a real impact on OPEC’s purchasing power, and their economies.
Therefore, the Real Global Price of oil is a better measure of the true price of oil, because it measures oil’s value relative to those who set the price - namely OPEC.”
As noted above, Marathon’s management requires I make this disclaimer: The opinions and analyses presented herein are entirely the author’s and do not represent Marathon Oil Company’s analyses, opinions, forecasts - or anything else. So this presentation does not reveal the secret, inner workings of Marathon’s oil price predictions.
Two oil prices are commonly reported: “Nominal” and “Real.” The “Nominal Price” is also called the price in dollars of the day (DOD). It is not corrected for anything.
The “Real Price” is the price corrected for inflation, usually using the American Consumer Price Index. It is also referred to as “in real terms.”
Many experts [circa 2000] have made grave prognostications about future oil prices based on analysis of the data series for the “Real Price” going back to 1900. They say, “corrected for inflation, over the last 70 years, the price of oil has averaged about $13/bbl.” But “Real Price” analyses are flawed because they only measure of the price of oil relative to the American Consumer.
So my question to the audience is, “Does the American consumer set the price of oil?”
A better measure of the price of oil is the price relative to the people who control oil production and price; which is OPEC and not the American consumer. This means looking at oil from a global perspective: the Real Global Price.
First, we have to establish just what the value of the U.S. dollar has been over the OPEC era of the last 40 years. For that, I use the value of the dollar relative to the G-7 currencies plus Switzerland. The reference basket is weighted with respect to the individual countries GDP. Note: there are many different methods to calculate the value of the U.S. dollar but all the different methods give about the same results.”
As a calibration, in Figure 5 I show the value of the U.S. dollar as calculated by the International Monetary Fund (IMF), and expressed in Special Drawing Rights (SDRs), the pseudo-currency of the IMF.”
I might have used the IMF’s SDRs as a proxy for the U.S. dollar’s value, but I did not for two reasons. First, I think most of the audience is intuitively familiar with exchange rate fluctuations between the U.S. dollar and, for example, the English Pound - not many people have heard of SDRs. Second, the IMF is loath to increase the value of the U.S. dollar above its original valuation, even when global currency markets actually pushed the dollar to record highs. For example, in 1985, the greenback soared. One US dollar could briefly buy one British pound. At that time, the IMF “capped” the dollar’s value.”
To correct for inflation, I used the GDP deflator for the reference basket of currencies, but, interestingly, the U.S. P.P.I. would have given the almost exactly the same results. Figure 7 is the Real Global Price of oil, corrected for exchange-rate fluctuations and for inflation.
The most important event in oil industry history in the 2nd half of the 20th century was the abandonment of the Bretton Woods Agreement in 1971. So, I’d like to first explain what the Bretton Woods Agreement was, and why it died.
Bretton Woods accord:
This monetary event, floating the dollar, changed the oil industry more than any other event in the 2nd half of the 20th Century. You, the people in this “audience,” are still feeling its effects today.
By fall, 1973, the price of gold tripled, and the price of corn and wheat doubled before the OPEC price increase of 1973.
Foreign countries that have large dollar deposits in U.S. banks, such as Saudi Arabia, see the value of their money drop by 21%. OPEC feels the pain.
1978-1980 Dollar Collapse (Figure 12)
This collapse was worse than the 1973 collapse.
1994-’95 collapse represented a turning point (Figure 15).
Latest Price Collapse (Figure 16)
In 1998, OPEC over-estimated demand and raised production just as the Asian currency melt-down cut oil consumption in Asia. Also, the Saudis wanted to bring discipline to over-producing OPEC member countries - in particular, Venezuela.
The nominal oil price fell to $10/bbl but was manifestly unsustainable because it again broke through OPEC’s “painful threshold” in RGP terms. This oil price melt-down was more important than ‘94-’95 crisis because it showed that a lot of countries shared the painful threshold. People came out of the woodwork to support higher oil prices. OPEC and non-OPEC countries alike agreed to cut production.
A commodity analysis corroborates the exchange rate story. Gold has always been a standard measure of any currency’s strength. Indeed, only in recent history has any currency not been backed by gold.
I call this section “Futurology” because I refuse to dignify price predictions as science. We can no more predict the price of oil than we can predict the stock market: all predictions prove wrong. I provide this section to demonstrate how the Real Global Price method works as a check of nominal price predictions.
I’ll to start by showing the future price scenarios I presented at AAPG in 1996 and how a Real Global Price analysis provides a clearer picture. In 1996, I presented a future worse-case scenario that oil would drop to $10/bbl (DOD) sometime in the near future - a lucky guess – and showed this low nominal prices was unsustainable when viewed in terms of the Real Global Price.
As we know, OPEC recently announced it has a new price target, as noted below.
Despite OPEC’s announcement, there is still much pessimism in the industry: “1998 could happen all over again, so we better gear up for $13/bbl (DOD) for the rest of our lives.”
Cooler business sense needs to be applied. Let’s convert OPEC’s stated price target from DOD to RGP and project the target range on a RGP curve. Let’s also give the pessimists their due and project out their dire predictions of $13/bbl (DOD) using RGP technique.
Which price projections, on a historical RGP basis, seem the most reasonable to you? Does $13/bbl fit the historic data?