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William DeMisHistorical Analysis of Real Global Price of Oil: Implications for Future Prices, by William D. DeMis, #70037 (2007).

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Historical Analysis of Real Global Price of Oil: Implications for Future Prices*

By

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])

Preface 
[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.

 

Abstract 
[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).

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

uPreface

uAbstract

uIntroduction

uTwo price curves

uFigures 1-3

uReal Global Price

uFigures 4-8

uMath right?

uReal global price

uHistorical retrospective

uFigures 9-16

uBretton Woods Agr

uPost-Bretton Woods

uCommodity analysis

uFigure 17

uFuturology

uFigures 18-20

uFuturology of today

uConclusions

 

Introduction

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 Price Curves (Figures 1, 2, and 3)

Figure 1. Nominal and real price of oil.

Figure 2. Common “analysis” of real price data.

Figure 3. Real Price of oil compared to percent variation in value of U.S. dollar on global currency markets (1970 base). The fallacy of “Real Price” analyses is that the value of the U.S. dollar has not been constant.

 

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.

 

Real Global Price of Oil
(Figures
4, 5, 6, 7, and 8) 

Figure 4. Value of U.S. dollar (1970 base = 100%).

Figure 5. Value of U.S. dollar relative to SDRs.

Figure 6. Percent changes in the value of the U.S. dollar from 1970 base.

Figure 7. Real Global Price of oil (RGP).

Figure 8. Real Global Price of oil (RGP) (Figure 7), with specific prices of $11/bbl and $19/bbl. Post 1986, oil prices have varied between $11 and $19/bbl with respect to this analysis.

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.”

 

Is the Math Right? 

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.”

 

Real Global Price 

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.

 

Historical Retrospective (Figures 9-16)

Figure 9. Real Global Price of oil and percent change in value of U.S. dollar, highlighting three major drops in the value of the dollar (‘73, ‘79-’80, and ‘94-‘95) after the Bretton Woods era.

Figure 10. 1973 dollar collapse.

Figure 11. Dollar devaluation leads to price increase.

Figure 12. ‘79-’80 dollar collapse.

Figure 13. ‘94-’95 dollar collapse, with Real Global Price.

Figure 14. Real Global Price and OPEC’s “painful threshold” in ’94-’95.

Figure 15. Real Global Price, with ’94-’95 highlighted, as OPEC regains purchasing power.

Figure 16. 1998 oil price collapse and recovery.

 

Bretton Woods Agreement(Figure 9)

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:

  • Meeting held in Bretton Woods, New Hampshire, in 1944 by Allied Powers to determine post-World War currency system.
  • U.S. dollar fixed at $35/oz of gold (dollar was backed by gold).
  • Agreement to fix currency exchange rates to a 1% trading range among signature countries (this later became IMF).
  • U.S. dollars and gold could be exchanged at ‘”Gold Window” by central banks of signature countries.
  • The U.S. became the world’s banker. The U.S. dollar became, and still is, the reserve currency of the world.
Bretton Woods’ demise:

  • Inflation in 1960’s, due to spending on the war in Vietnam and Johnson’s “Great Society” created an excess of dollars on global markets. The dollar was perceived as being overvalued.
  • There was a “run” on the US’s gold bullion reserves. European countries rushed to exchange their U.S. dollars for gold bullion (at $35/oz) and sell the bullion in Switzerland for $45/oz.
  • By July, 1971, only $10 billion of gold was left in Fort Knox.
  • August 15, 1971: President Nixon closes “Gold Window.” Bretton Woods was dead. The dollar was “floated.”

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.

 

Post-Bretton Woods

  • The dollar “floated” like a rock.
  • Two U.S. dollar devaluations in 14 months (Figures 10 and 11).
    • December, 1971 - U.S. dollar is devalued 11%.
    • February, 1973 - U.S. dollar is devalued 10%.

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)

  • OPEC openly explores alternatives to pricing oil in US. Dollars.
  • Revolution in Iran cuts production; nominal price soars to record.
  • OPEC drops “alternative” pricing plans.

1994-1995 Dollar Collapse (Figures 13 and 14)

This collapse was worse than the 1973 collapse.

  • OPEC’s purchasing power parity was back to 1973 level, but their economies had changed a lot since 1973.
    • Since 1973, many OPEC countries have gone from underdeveloped nations, with mostly rural populations, to modernized urban countries with a burgeoning middle class, all built on one commodity - oil.
    • Here is an indicative fact: in 1973, OPEC countries consumed about 0.7 mmbopd. By 1995, they consumed 5 mmbopd. This 7- fold increase in consumption is a measure of OPEC’s growing middle class.
    • In addition, key OPEC countries provided subsidized medical care, education, etc. - costly programs they did not have in 1973.
  • OPEC needed to regain purchasing power and openly said so before the June, 1995 meeting.

1994-’95 collapse represented a turning point (Figure 15).

  • OPEC tipped its hand. Prior to June, 1995 OPEC Meeting:
    • OPEC Secretary General suggests alternative pricing should be considered.
    • Iranian Oil Minister recommends oil be priced in Yen.
    • Algerian Oil Minister recommends oil be priced in SDRs.
    • United Arab Emirates Oil Minister recommends oil be priced in basket of currencies.
  • This was the under-reported news of the decade!
  • But the alternative pricing schemes to offset the eroding dollar had the same problems they had in 1980: they were too impractical. The solution was simple: raise nominal prices.

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.

 

Commodity Analysis
(Figure 17)

Figure 17. Gold and oil prices (D.O.D.).

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.

 

“Futurology”
(Figures 18, 19, and 20)

Figure 18. Projected nominal oil price: Hypothetical forecast made in 1996.

Figure 19. Projected real global price: Real global price analysis, 1996.

Figure 20. Real Global Price Projections, made in 2000.

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.

 

Futurology of Today (i.e., 2000)

The projections in Figures 18 and 19 were future price scenarios to test the Real Globa Price method from 4 years ago (in 1996). So what about today? [meaning 2000]

As we know, OPEC recently announced it has a new price target, as noted below.

  • March, 2000 OPEC Meeting
    • Unprecedented agreement. Venezuelan oil minister to cut or increase production when certain, undisclosed levels are reached (“with a phone call”).
    • Keep oil price within a range.
    • Saudi Arabia’s oil minister said range he has in mind is “$20 to $25/bbl for North Sea Brent (~$22 to $27/bbl for WTI).” [Quotes from WSJ, March 31, 2000]

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?

 

Conclusions

  • OPEC has not been able to pursue a “market-share policy” because of its lost purchasing power from declining dollar. [First stated in 1996 AAPG presentation.]
  • When supply catches up with demand, OPEC will raise nominal prices or possibly abandon the US dollar as a basis for pricing oil. (First stated in 1996 AAPG presentation.)
  • Current projections of nominal $13/bbl oil prices appear improbable, based on both technical and fundamental analyses.
  • Very recent rise in the value of the U.S. dollar [2000 presentation] could allow OPEC to shift price to the lower end of stated target range. OPEC’s purchasing power would be maintained by the increase in dollar value (e.g., in the last few months, the euro has dropped from $1.18 to only $0.90).
  • Therefore exchange rate variations can work against bullish price scenarios. It all depends on the value of the greenback.
  • Exchange rates are an important factor to consider in analyzing the history of oil prices and in making price predictions.

 

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