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How the World's reserve currency value is determined, and what decides putting a price on oil?

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     on  27 August 2013    

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Company secretaries, foreign currency managers, commodity traders, bankers, chief risk and investment officers, CFO's and Board members are often concerned with how the value of the World's reserve currency U. S. Dollar is determined. They are also asked to explain the global phenomenon as to what makes the oil prices so high, given the fact that oil is traded in U. S. Dollars.

 

This article has endeavored to analyse markets pandemonium that impacts almost all businesses, consumers and global economy, and provides treasurers, company secretaries and CFO's with ways for value creation in efficient deployment of capital in a given market and financial risk environment.

 

1. Dollar Is Losing Value over the Long-term - five ways No matter how you measure it, the dollar is losing value over the long-term.

 

Here's why:

 

(i) U.S. debt is more than $16 trillion. Foreign holders of this debt are concerned that the U.S. will let the dollar value decline so the relative value of its debt is less -a higher denominator USD rate amount when applied to debt denominated in say euro will give a lower debt amount.

 

(ii) Large debt could force the U.S. to raise taxes to pay it off, which would slow economic growth.

 

(iii) As more countries join or trade with the European Union, demand for the euro increases.

 

(iv) Foreign investors are diversifying their portfolios with more non-dollar denominated assets.

 

(v) As the dollar loses value, investors are less likely to hold assets in dollars as they wait for the decline to stop.

 

2. Methods to measure dollar value -three methods U. S. dollar's value can be measured by three methods:

 

(i) Exchange rates,

(ii) Treasury notes, and

(iii)Foreign exchange reserves (the amount of dollars held by foreign countries).

 

These three measurements usually are in sync with each other.

 

3. Dollar Value Is Measured by Exchange Rates U.S. dollar is most easily measured by its exchange rate, which compares its value to other currencies. Currency exchange rates allow you to determine how much of one currency you can exchange for another. A currency's forex value depends on a lot of factors, including central bank interest rates, the country's debt levels, and the strength of its economy.

 

Most countries allow their currencies to be determined by the forex market. This is known as a flexible exchange rate. Example of dollar exchange rate with euro:

 

• 2012 - dollar lost value against the euro, as it appeared the eurozone crisis was being managed. By the end of 2012, the euro was worth $1.3186.

 

• 2011 - The dollar's value against the euro fell 10%, and then regained ground. As of December 30, 2011, the euro was worth $1.2973.

 

• 2010 - The Greece debt crisis strengthened the dollar. By year end, the euro was only worth $1.32.

 

• 2009 - The dollar fell 20% thanks to debt fears.

 

By December, the euro was worth $1.43.

 

• 2008 - The dollar strengthened 22% as businesses hoarded dollars during the global financial crisis. By year end, the euro was worth $1.39.

 

• 2002-2007 - The dollar fell 40% as the U.S. debt grew 60%. In 2002, a euro was worth $.87 v. $1.44 by December 2007. (source: Federal Reserve rates).

 

4. Dollar's Value Is Measured by Treasury Notes Dollar's value is usually in sync with demand for U.S. Treasury notes. The Treasury Department sells notes for a fixed interest rate and face value. Investors bid at a Treasury auction for more or less than the face value, and can resell them on a secondary market. High demand means investors pay more than face value, and accept a lower yield. Low demand means investors pay less than face value and receive a higher yield.

 

That's why a high yield means low dollar demand -- until the yield goes high enough to trigger renewed dollar demand.

 

(i) Example: Yield rates on U. S. Treasury Notes

 

• 2012 - The dollar strengthened significantly, as the 10-year Treasury note yield fell in June to 1,443 -- a 200-year low. By the end of the year, the yield had risen to 1.78%. (Remember, low yields mean a strong demand for Treasuries and dollars).

 

• 2011 - The dollar weakened in early spring but rebounded by the end of the year. The 10-year Treasury note yield was 3.36% in January, rose to 3.75% in February, then plummeted to 1.89% by December 30.

 

• 2010 - The dollar strengthened, as the yield fell from 3.85% to 2.41% (January 1-October 10). It then weakened due to inflation fears from the Fed's QE2 strategy.

 

• 2009 - The dollar fell as the yield rose from 2.15% to 3.28%.

 

• 2008 - The yield dropped from 3.57% to 2.93% (April 2008-March 2009), as the dollar rose.

 

• Prior to April 2008, the yield stayed in a range of 3.91%-4.23%, indicating a stable dollar demand as a world currency. (Source: U. S. Daily Treasury Yield Curve Rates).

 

(ii) Dollar value impacted by huge debt burden Value of the dollar, whether measured by exchange rates or Treasury yields, is undermined by the $16 trillion U.S. debt. During the recession, investors wanted a safe investment, which strengthened the dollar. When global confidence picked up, the dollar resumed its downward trend and Treasury yields rose as long as the Federal government auctioned more notes to fund the debt. Fed's quantitative easing plan sopped up some of the excess debt by monetizing it. The dollar benefited from a temporary flight to safety, as investors were worried about the outcome of the 2012 U. S. Presidential campaign and the fiscal cliff.

 

5. Value of the Dollar as Measured by Foreign Currency Reserves Dollar is held by foreign governments who have an excess of dollars, which they hold in foreign currency reserves.

 

Excess happens when countries, such as Japan and China, export more than they import. As the dollar declines, the value of their reserves also declines. As a result, they are less willing to hold dollars in reserve. They diversify into other currencies, such as the euro or even the Chinese Yuan. This reduces demand for the dollar, putting further downward pressure on its value.

 

(i)Dollar reserves are declining in relative terms As of Q3 2012 (most recent report), there was a record $3.716 trillion in foreign government reserves held in dollars. This represents 61.8% of total measurable reserves, down from Q3 2008, when dollars comprised 67% of reserves. Since the percentage of dollars is slowly declining, this means that foreign governments are slowly moving their currency reserves out of dollars. In fact, the value of euros held in reserves increased from $393 billion to $1.45 trillion during this same time period, despite the eurozone crisis. Despite this growth, this is still less than half the amount held in dollars. (Source: IMF).

 

(ii) How the Value of the Dollar Affects the U.S. & global economy When the dollar declines, it makes American-made goods cheaper and more competitive when compared to foreign produced goods. This helps increase U.S. exports, boosting economic growth. However, it also leads to higher oil prices in the summer, since oil is priced in dollars. Whenever the dollar declines, oil producing countries raise the price of oil to maintain profit margins in their local currency.

 

(iii) Example of how the dollar value changes affect the U. S. economy

 

• For example, the dollar is worth 3.75 Saudi riyals. Let's say a barrel of oil is worth $100, which makes it worth 375 Saudi riyals. If the dollar declines 20% against the euro, two things happen.

 

• First, the value of a barrel of oil has declined 20% to the Saudis.

 

• Second, the value of the riyal, which is fixed to the dollar, has also declined 20% against the euro.

 

• To avoid this, the Saudis raise the price of oil, which they do by threatening to limit supply. You notice this when you pay more for gas each week.

 

6. What decides putting a price on oil? -oil price volatility analytics If the global economy is healthier than in 2008, why wouldn't oil prices be higher? That's because there are many more outlets for investment funds. In 2008, the global markets were so risky and uncertain, investors turned from stocks, bonds and even housing to the U.S. dollar, gold and oil. In 2012, despite uncertainty around the eurozone crisis, investors have many more options. The stock market is rising, the bond market is less risky, and even housing is seen as less dismal. Although the global market is still in slow growth mode, it is stabilizing, and that means oil prices shouldn't break the peak hit in 2008.

 

7. Reasons for high oil prices in 2012 onwards Oil prices started rising much sooner in 2012 than they did in 2011. The price for WTI crude oil broke above $100 a barrel on February 13, 2012 two weeks earlier than in 2011. Rising oil prices drove gas prices above $3.50 a gallon that same week. Gas prices had already breached $3.50 a gallon on the East and West coasts in January 2012. By March 2012, Brent Crude Oil (which is more expensive than WTI) peaked at $125 a barrel. It settled down to $95 a barrel in June, but rose $113.36 by August 2012. Normally, oil prices drop in the Fall and Winter. However, commodities futures traders were bidding up oil prices to offset what the Fed's expansive monetary policy. Traders were betting the dollar would drop, which drives up oil prices. They were wrong about the dollar, but oil prices rose despite lower demand.

 

8. Oil prices driven by commodities markets People were concerned because gas and oil prices rose earlier than in the past. However, less and less of oil prices are due to supply and demand. More and more of it is based on the expectations of commodities markets. Commodities trading drove up oil prices.

 

Why?

 

Although the EIA pinned part of the blame on volatility in Venezuela and Nigeria, it warned of an influx of investment money into commodities markets. Investors were stampeding out of the falling real estate and stock markets. Instead, they diverted their funds to oil futures. This sudden surge drove up oil prices, creating a speculative bubble. (Source: EIA - short term energy outlook). This bubble soon spread to other commodities. Investor funds swamped wheat, gold and other related futures markets.

 

9. Trading of Oil futures contracts by traders Commodities traders look at projected supply and demand to help them decide how high to bid on oil futures prices. However, if all traders think the price of oil will be high, they can create a self-fulfilling prophecy by bidding up oil prices. This can create high oil prices even when there is plenty of supply on hand. Once this starts, other investors will bid on oil prices just like any other commodity, such as gold, creating an asset bubble.

 

(i)What is an oil futures contract? Oil futures contract is an agreement to buy or sell a specified amount of barrels of oil at a specified price on a specific date. Futures contracts are executed on the floor of a commodity exchange by traders who are registered with the exchange or with the Commodities Futures Trading Commission. Although these contracts are binding and based on real commodities, speculative investors trade them on a market with no intention of actually purchasing or delivering any products. Savvy investors can take advantage of changing commodities prices by trading futures contracts. You can make a lot of money, but you could also lose big; you could call it legalized gambling.

 

(ii) Purpose of futures contracts and use by oil producers Writers create contracts in order to lock in prices in case of fluctuation. For example, if you produce oil and you think prices will go down (from $100 -current market price to $97 -your price in future), you can write contracts to lock in your prices ($97) now, to hedge against risk of falling oil prices beyond $97; So, if future price goes down to $95, you will gain $2 a barrel on contracted quantity. If future price is $98, you will lose $1. Similarly, if you believe that prices will go up (from $100 to $103), you'll buy contracts that lock in your prices ($103) now; if future price goes up only to $102, you will lose $1 a barrel. If future price is $104, you will gain $1. Futures contracts are often used by pairs of business professionals to hedge their own bets.

 

(iii) Use of oil futures by speculative traders Traders who aren't interested in actual products will buy and sell these contracts in order to benefit from changing prices. If you think that prices will go up ($82), you'll buy the futures contract to deliver goods at $80 a barrel, and then sell them to someone else (at prevailing oil price $82 on date of sale of the contract) before the due date -you gain $2. If you buy the same position at $80 but the price begins to decline ($77) before the contract due date, you can sell the contracts to someone else who still thinks that prices will rise beyond $77 or that they'll hold steady for a profit. -you lose $3.

 

(iv) Risk for investors (speculative traders) Major risk for investors is that oil prices will move in the opposite direction of your position (oil producer or another speculative trader or actual user -in short, commodities trader). You (investors or traders) must get out of the position before the due date, or you'll end up with a lot of oil at your doorstep that will cost you a lot of money. If necessary, you'll have to sell at a loss ($2, actual oil price in future being at $78) to close out your position before the due date of the contract -contract price $80. Both parties of a "futures contract" must fulfill the contract on the settlement date.

 

(v) Tip -what should be the price direction to buy or sell a futures If you think the price of oil will rise (from $80 to $84), buy low-priced ($81-$83) oil contracts -you will gain $1-$3; if oil price will fall (from $80 to $76), buy high-priced ($77-$79) oil contracts -you will gain $1-$3. Your price bet should be in the opposite direction to future market oil prices, to enable you to gain either or contract delivery on due date or on getting out of the Contract position before its due date.

 

10. All-Time High Was $145 a Barrel Oil prices hit an all-time high of $145 a barrel in July 2008. This drove gas prices to $4.00 a gallon. Most news sources blamed this on surging demand from China and India, combined with decreasing supply from Nigeria and Iraq oil fields. However, even then this wasn't logical, since the U. S. economy was already in a recession.

 

11. Supply and Demand Are Not Alone in Driving Up Oil Prices -price rise in recession too Price of oil is driven by much, much more than supply and demand. This was proven in 2008. Thanks to the recession, global demand in 2008 was actually down and global supply was up. Prices rose, nevertheless. Oil consumption decreased from 86.66 million barrels per day (bpd) in the fourth quarter 2007 to 85.73 million bpd in the first quarter of 2008. At the same time, supply increased from 85.49 to 86.17 million bpd. According to the laws of supply and demand, prices should have decreased. Instead, they increased almost 25% in that time - from $87.79 to $110.21 a barrel. (Source: U. S. Energy Information Administration -EIA).

 

12. Oil prices are raised to maintain profit margins High oil prices are also driven by a decline in the dollar. Most oil contracts around the world are traded in dollars. As a result, oil-exporting countries usually peg their currency to the dollar. When the dollar declines, so do their oil revenues, but their costs go up. Therefore, OPEC must raise the price of oil to

 

•  Maintain its profit margins and •  Keep costs of imported goods constant. (Source: USA Today, Oil Briefly Spurts Near $104 per Barrel, March 3, 2008).

 

13. Risk of alternative fuel source drops oil prices However, OPEC doesn't want oil prices too high, or alternative fuel sources start to look good. OPEC has said its target price for oil is between $70 and $80 a barrel. In 2008, Saudi Arabia announced it would increase supply. This was one reason prices started to drop.

 

14. Oil reserves, a monopoly in most countries -responsible for high prices Oil reserves are a monopoly in most countries which have oil reserves. Prices remain high in a monopoly market structure. Additionally, with a view to increase their negotiating powers of supplying and pricing, a few countries have joined hands together, like the OPEC in 1960. These exporters have done so to keep the price of oil fairly high. Since oil is a non-renewable resource, when it's gone these exporters have nothing left to sell. Therefore, they want to get the highest profit possible while it lasts. They can only do this if they collude, rather than compete.

 

The 12 OPEC members hold 80% of the world's proven reserves. The biggest importers are the U.S., the European Union and China. There is 1.532 trillion barrels of oil in the world as of January 2012. That's enough to last around another 50 years, since the world uses 84 million barrels per day. Reserve keeps fluctuating due to oil reserves growth.

 

15. World crises and oil prices - examples

 

(i)Oil energy is attributable to the massive economic advances in the 20th century and into the 21st. Oil accounts for 40% of the World energy-mix. Importance of oil was realized when in October 1973. OPEC nations stopped exporting oil to the U. S. and other western economies consequent to the Arab-Israel conflict in 1967. One of the long-term effects of the embargo was an economic recession throughout the world. Inflation remained above ten percent in U. S. and unemployment was at its record high.

 

The era of economic growth, in effect since World War II, ended in 1973. Arabs began to ship oil to Western nations again, but this time at inflated prices. Speed limits and fuel economy stickers are a result of the Governments' efforts to preserve oil. Third World states discovered that their natural resources, on which they depended upon, specifically oil, could be used as a weapon in both political and economic situations. The rising oil prices continued to be a threat to not only America's economy, but also that of the world. President Jimmy Carter would later call the oil situation in the 70's "the moral equivalent of war." Never had the price of an essential commodity risen so quickly and dramatically.

 

(ii) Iran crisis -prices of oil and gasoline rose This happened in January 2012, after inspectors found more proof that Iran was closer to building nuclear weapons capabilities. U.S. and European Union began financial sanctions. Iran situation remains a wild card for oil prices. Potential world crises in oil-producing countries can also dramatically increase oil prices. That's usually because traders anticipate the crisis will limit supply.

 

(iii) World unrest -Arab Spring -Oil prices rose but declined later World unrest also caused oil prices to rise in the spring of 2011. In March 2011, investors became concerned about unrest in Libya, Egypt and Tunisia in what became known as the Arab Spring. Oil prices rose above $100 a barrel in early March, reaching its peak of $113 a barrel in late April 2011.

 

(iv) Effect of Disasters on Oil Prices - natural

 

• Hurricane Katrina -Oil and gasoline prices rose Natural and man-made disasters can drive up oil prices if they are dramatic enough. Hurricane Katrina caused oil prices to rise $3 a barrel, and gas prices to reach $5 a gallon in 2005. Katrina affected 19% of the nation's oil production. It came on the heels of Hurricane Rita. Between the two, 113 offshore oil and gas platforms were destroyed, and 457 oil and gas pipelines were damaged.

 

• Mississippi River Flooding May 2011 -Gasoline prices rose Gas prices rose to $3.98 a gallon. Traders were concerned the flooding would damage oil refineries.

 

(v) Effect of Disasters on Oil Prices -man made

 

• Exxon-Valdez oil spill -Oil price did not rise

 

• BP oil spill in the Gulf of Mexico-Oil and gasoline prices barely rose BP oil spill spewed more than 18 times the oil than did the Exxon Valdez. Yet, oil and gas prices barely budged as a result.

 

Why?

 

•  For one thing, global demand was down thanks to a slow recovery from the 2008 financial crisis and recession. Second, even though 174 million gallons of oil was spilled, it was over a long period of time, and it wasn't a large percentage of total oil used by the U.S. In fact, it was only about 9 days' worth of oil. U.S. consumed 6.99 billion barrels in 2010, according to the U.S. Energy Information Administration.

 

That's a little over 19 million barrels per day.

 

16. World global oil demand weighs on U. S. forced budget cuts -price has fallen According to the IMF, the U.S. spending cuts could cost the world's biggest oil consumer about 0.5 percent of its economic growth, a factor that could weigh on global oil demand. U.S. crude has fallen around $8 per barrel over February 2013. Fall in oil prices is coincidental to forced budget cuts effective 1 March 2013. U.S. oil futures fell to their lowest level in 2013 on 4 March (below $90) in reaction to weak U. S. economic data, Europe's malaise, slowing growth in China and indicators that oil markets are amply supplied and is unlikely to reverse course without signs of world economy improving.

 

Recently since June 2013 onwards, crude oil rates have again jumped and are hovering around $106 a barrel in August 2013 on dipped inventories due to growth data releases in the U. S., Eurozone, Japan and China.

 

17. Crude oil grades as benchmark in oil pricing (oil markets) Types of crude oil grades used as a benchmark in oil pricing are:

 

(1) Brent crude from North Sea.

(2) West Texas Intermediate (WTI) -benchmark for U. S. crude market- which is relatively low density, and sweet because of its low sulfur content.

(3) Other important oil markets include the Dubai Crude, Oman Crude, and the OPEC Reference Basket.

 

18. Concluding comments Business managers and professional leaders like company secretaries would find it satisfying to drive the businesses of their entities by developing expectations of

 

(i) valuation of the U. S. Dollar and

(ii) oil prices in various oil markets like Brent crude, WTI, OPEC, NYMEX, thus laying down a sound strategy for spending and investing the scarce resource of capital most effectively, profitably and prudently, in an environment that is fraught with high risks and volatility in global economy and markets.

 

(Sources have been quoted in the article) Specimen Currency Rates U. S. $ Euro € 1.295 GBP £ 1.514 Yen ¥ 95.541 Specimen Crude Oil Prices Crude market Date of price Rate per barrel Change in price over previous day WTI (West Texas) 15 April 2013 day end $88.71 2.58 2.80% Brent Crude Oil 15 April 2013 day end $100.63 2.41 2.33% 1 Year forecast $109/barrel

 

By: CS.Anand Varma,

FCS Company Secretary

varma1002003@yahoo.co.in August 2013

Published in Others
Source : U. S. Treasury Daily Yield Curves, U. S. Fed exchange rates
Views : 4786

Other Articles by Anand Varma, FCA; FCS.




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