![\"brent_oil_price_per_barrel_.jpg\"](\"http:\/\/beta.next-finance.net\/wp-content\/uploads\/2014\/12\/brent_oil_price_per_barrel_.jpg\")
<\/p>\nDespite rising geopolitical tensions (Iraq, Libya, Russia), oil prices have
\nshed more than one third of their value since peaking at $115 at the end
\nof June (see chart 1). Although the fall in the oil price is good news for
\nwestern consumers, this phenomenon should nonetheless be analysed in a global context in order to draw any conclusions regarding asset allocation.<\/p>\n
<\/p>\n
It is true to say that weaker oil prices impact western households in the same way
\nas a cut in VAT, in that it enhances purchasing power within a segment of
\ndomestic spending which is otherwise difficult to reduce. However, the question
\narises as to whether the fall in the oil price corresponds to factors which are
\nendogenous or exogenous to the global economic climate.<\/p>\n
In the case of an exogenous shock, such as the introduction of new extraction
\ntechnologies for example, a drop in the oil price is unambiguously positive for
\ngrowth and the financial markets (with the obvious exception of oil sector
\nequities). In this current context however, prices have been driven lower by a
\ndowngrade in growth forecasts for global oil demand, particularly among
\nemerging markets. The fall in crude prices is therefore more symptomatic of the
\ndeterioration in worldwide growth outlook than a positive shock in the global
\neconomy. It is acting as an inherent buffer against the slowdown in demand, but
\nwithout entirely cancelling it out. In the USA in particular, real domestic income
\ngenerated by the fall in the price of oil would be entirely offset by a 2.5% decline
\nin US exports, which appears low in the light of downgrades in global growth.<\/p>\n
However, the current price correction has been surprisingly sharply in comparison
\nwith the preceding episode of doubt regarding growth in demand among emerging
\nmarkets, particularly China, during the first half of 2012. In this case, macrofinancial
\nfactors come into play, including oil-price setting. The major difference
\nbetween the two bearish episodes is that in 2012, US real long-term rates were
\neasing (the Fed\u2019s quantitative easing programme), whereas rates are now
\nsteepening marginally. Hotelling’s rule intuitively explains the link between real
\ninterest rates and the price of a non-renewable storable commodity (such as oil).
\nWhen real interest rates are low, producers maximise the value of their mining
\nresource stock by conserving reserves underground, thus driving prices higher
\ndue to a lack of supply, rather than extracting their resources and selling them
\ncheaply on the open market and investing their revenues at low real interest
\nrates. Chart 2 illustrates this negative correlation between the oil price and US
\nreal long-term rates.<\/p>\n
![\"oil_price_and_real_lt_rates.jpg\"](\"http:\/\/beta.next-finance.net\/wp-content\/uploads\/2014\/12\/oil_price_and_real_lt_rates.jpg\")
<\/p>\n
Furthermore, Hotelling\u2019s theory should also be applied to forex markets. Oil
\nproducers effectively receive income in dollars, the denomination currency of most
\ncommodities markets. Major producing countries (Middle East, Russia) also enjoy
\nhigh saving rates, which helps smooth out mining resource revenues over time.
\nThey therefore have heavy revenue flows in dollars which are partially invested as
\nsavings in the financial markets. These countries already have very large foreignexchange
\nreserves in dollars, and seek to marginally reduce their dependence on
\nthe greenback. When crude prices are high, diversification of dollar-denominated
\nsavings by oil-producing countries into other currencies therefore generates a
\nselling flow of dollars in the forex market. Thus, there is also an inverse
\ncorrelation between the price of oil and the dollar exchange rate, as illustrated in
\nchart 3.<\/p>\n
![\"oil_and_dollar_exchange_rate_vs_currency_basket.jpg\"](\"http:\/\/beta.next-finance.net\/wp-content\/uploads\/2014\/12\/oil_and_dollar_exchange_rate_vs_currency_basket.jpg\")
<\/p>\n
The accelerating fall in the oil price can therefore be linked to the sharp increase
\nin the dollar since early summer. The dollar rally stems from monetary decoupling
\nbetween the USA and other developed countries. The US economy is growing at a
\nrate of 3% and is fast approaching full-employment, justifying a normalisation of
\nFed policy, whereas the euro zone and Japan are faced with the threat of deflation
\nwhich renders their household and public debt potentially less sustainable. While
\nthe Fed is considering the best timing to start hiking rates, the ECB and the Bank
\nof Japan have announced, over recent months, their intention to significantly
\nincrease the size of their balance sheets in order to weigh on the entire yield
\ncurve. The explicit (in the case of Japan) or implicit (in the case of the ECB) aim
\nof this intervention is to drive the domestic currency lower against the dollar. The
\nSwiss National Bank has already capped the Swiss franc against the euro.
\nMeanwhile, the Bank of England and the Swedish Riksbank are also considering
\nintervening to prevent their currencies appreciating too sharply against the
\nEuropean single currency, which is being driven lower by the ultraaccommodating
\nstance assumed by the ECB. On the other hand, the Fed has so
\nfar issued no significant comments regarding the strength of the dollar, meaning that the greenback remains the primary vector for the euro to express its
\nweakness. This accounts for the surge in the dollar, and, in correlation, the
\nexaggerated fall in the price of the barrel. The dollar therefore remains, for the
\ntime being, the victim of the opening clashes of the potential \u2018currency war\u2019
\nbetween the G7 countries. Furthermore, the correlation between the dollar and
\nthe price of oil is self-perpetuating: European and Japanese monetary easing is
\ndriving the dollar higher and weakening the oil price, which weighs on European
\nand Japanese inflation and provides the central banks with the pretext to further
\nease their monetary policy. This is the mirror image of the 2008 dollar-oil spiral.<\/p>\n
The fall in the oil price is thus attributable to a real phenomenon (the downward
\nrevision in global energy demand), but which we consider to be amplified by
\nmacro-financial interest-rate issues (steepening US real rates) and foreign
\nexchange factors (dollar rally). Its significance for the current state of global
\ngrowth must therefore be viewed in perspective – the fall in the oil price greatly
\nexaggerates a downturn in global growth in our opinion – and it would therefore
\nbe unwise to consequently adopt an over-pessimistic view regarding the current
\nvaluation of risky assets. Furthermore, the oil price may rebound once the bullish
\ndollar trend is inversed. The Obama administration may also bring matters to a
\nclose, judging that the dollar alone should not have to bear the burden of an
\nadjustment among the European and Japanese economies. The US Treasury
\nSecretary Jack Lew has already expressed this sentiment. The oil price is
\ntherefore likely to remain volatile throughout 2015, as the currency war wages
\non.
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