Demand for oil is relatively inelastic, meaning that a modest oversupply can cause prices to crater. But the North American shale boom has been going strong since 2008—so why didn't oil prices slump sooner?
While it's true that oil supplies grew more quickly than global demand in 2014, the divergence was hardly abrupt—and there was no sudden falloff in demand that could be compared to the nearly instantaneous supply shocks that caused price spikes in the past. Instead, underlying trends that had been building steadily for years seemed to converge simultaneously, sending prices tumbling. And one of those trends in particular, moving global currencies, may be a significant factor in oil's price collapse.
The global oil market is priced in US dollars, regardless of where the oil is produced and consumed—so even when oil is drilled in Saudi Arabia and sold to Germany, it's paid for in American currency.
Usually, this has little impact on prices; the dollar has rarely been volatile, especially compared to oil prices. That is, until 2014.
Until last year, the Federal Reserve had adopted accommodative monetary policies that kept the dollar cheap. Low interest rates and massive quantitative easing programs pushed the dollar's value down.
The climate shifted in 2014, though—while relatively robust growth for the US economy signaled an interest rate hike on the horizon, persistent weakness in Japan and the eurozone prompted their central banks to launch asset purchasing programs. The divergence caused the dollar to strengthen dramatically, gaining 60 percent against the yen and 22 percent against the euro.
All things being equal, a rising dollar should push the price of oil up in foreign markets, in the same way that the strong dollar has made American exports more expensive. For example, when each euro was worth $1.40 USD, a barrel of oil (at $100 USD per barrel) cost Europeans €71. But when the European Central Bank (ECB) announced its easing program, the euro fell to $1.10 USD, and the same barrel of oil should have shot up to €91 on the European market.
Of course, all things are not equal. Prices seek equilibrium—which for the European market should be much closer to the original €71 than the new €91. However, if the price of oil remains steady in euros, its price must then fall in dollars.
Since Europe accounts for 20 percent of the global oil market (and Japan another 5 percent), it should be no surprise then that the dollar's rapid rise closely mirrored the sudden collapse of oil prices last year.
Both the price of oil and global currency markets should begin stabilizing and will likely move back—albeit slowly—toward historic norms later this year and into the next. The ECB has announced that it intends to taper its current quantitative easing program in September 2016, and the strengthening eurozone economy seems likely to preclude a second round of easing. As monetary policies move back into alignment across the developed world, the dollar will likely give back some of its gains.
The dollar's slide should then cause oil prices to rise—but oil's climb is unlikely to be as steep as its fall. Supply growth is still outpacing demand, and rising prices may prompt a revival of drilling activity in North America, where the shale boom has temporarily paused. That said, a falling dollar—and the return of growth abroad—are likely to bring some relief to the energy sector in the coming year.
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