Currency Exchange Rate Impact to WTI Crude

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1 Currency Exchange Rate Impact to WTI Crude Relatively strong USD. 1.17EUR per USD. In this case,the USD is able to acquire 1.17EUR. The inverse is 0.85USD per EUR. Relatively weak USD. 0.63EUR per USD. In this case, the USD is only able to acquire 0.63EUR. The inverse is 1.58USD per EUR. Sources: cmegroup.com and oanda.com High oil prices are a good thing for companies producing oil because it raises the sales price of the product those companies sell, and likely its profit. What drives high oil prices? The price of WTI crude oil (WTI is impacted differently than Brent or North Sea Crude) is impacted by several variables including the cost to extract the resource, supply and demand, political tension or war, and speculative trading activity. Another variable that has a significant impact to crude oil is the relative strength or weakness of the USD in comparison to other currencies. In the chart, the USD is compared to the Euro. Currencies can only be compared two at a time as the relative strength and weakness is dependent on the other currency. The average November 2000 exchange rate yielded 1.17EUR per USD. For each USD, one can purchase 1.17EUR. The average July 2008 exchange rate yielded 0.63EUR per USD. For each USD, one could only purchase 0.63EUR. The more EUR one can buy with a USD, the stronger the USD. Therefore, the dollar was stronger when 1.17EUR could be purchased with 1 USD in Nov The perceived relationship between crude oil and the USD relative strength or weakness compared to the EUR is clear. Two questions I ask are why does the relationship exist and are there lurking variables that explain the increase in oil prices other than dollar relative strength. Using this EUR/USD example, a US citizen paid in USD can buy more EUR denominated products in 2000 compared to 2008, all else equal. As an example of how foreign exchange rates impacts purchasing power for imports, let s assume we want to purchase a Rolls-Royce Phantom for 250,000EUR. Then we will go back to answering the question of why a weak dollar increases oil prices. 1

2 Currency Exchange Rate: USD & EUR Impact of USD Imports to Prices (US Perspective) As laid out in the example above, when the USD is strong relative to the EUR, as it was in Nov 2000, the price of products denominated in EUR is cheaper for Americans. Keep in mind that the relationship between two foreign currencies is inverse. The weakening of one currency results in an opposite strengthening in the other currency. So when the holder of USD can buy more in EUR, the holder of EUR can buy less in USD. In Nov 2000, a holder of USD can purchase a Rolls-Royce priced at 250,0000 EUR for 213,620 USD based on the Nov 2000 exchange rate. In Jul 2008, Americans can no longer get that car with $213,620 hard-earned USD. Sadly, we could only get 54% of the car since it costs $394,571 in Jul 2008 USD. The weakening of a local currency makes foreign goods more expensive pushing demand lower from the country with the weakening currency. If we have EUR dollars however, goods and services denominated in USD become cheaper. Europeans can buy U.S. products and services more cheaply in the U.S., which is why Europeans increasingly bought flights to the U.S. to shop when the USD was weakening vs. the EUR. 2

3 Currency Exchange Rate: USD & EUR Impact of EUR Imports to Prices (European Perspective) Going back to our oil example, oil is a global product denominated in USD. When the USD weakens, oil becomes relatively cheaper for any country s currency which gains strength compared to the USD, like the EUR in this example. Additionally, all else equal, ex-us demand increases due to the relative cheap price of oil for foreign countries. More purchasing power for ex-u.s. countries and affordability for foreign currencies are the reasons that a weak USD pushes crude oil prices higher. In the example above, an oil price of $80 assumed to be the same for Nov 2000 and Jul 2008 reflects the cheaper price of oil to Europeans by $43/bbl or 46% due solely to the USD s weakness compared to the EUR. 3

4 Currency Exchange Rate: USD & EUR Impact of EUR Imports to Prices (European Perspective) The above chart is very similar to the last page with the only exception being the use of actual crude oil prices instead of the example using $80/bbl theoretical prices. In this example the price of a bbl of oil increases by 44 EUR or 110% when priced in EUR. That might sound like a significant price increase over an eight year time period. The price of a bbl of oil increases by almost 100 USD or 288% over the same time period. So while the EUR price of a bbl of oil has increased significantly, it s increased significantly less than the USD. What would be the price of a bbl of oil in USD if the USD maintained it s relative value compared to the EUR from Nov 2000 when the USD was stronger? To figure that out, we want $/Bbl in Nov 2000 terms so we divide 0.85USD by 1.58USD and multiply by today s crude price to calculate about $72/bbl, a currency neutral increase of 38 USD or 110%. It s not a coincidence that this price increase is the same as the EUR price increase. To see a graph of what comprises the price increase of oil in general terms from Nov 2000 to Jun 2011, refer to the next page. Based on currency relationships discussed, a weakening USD will likely result in higher WTI crude prices, and higher profits for companies selling crude oil. Pay attention to the USD relative strength and see what happens to crude prices. In general, US citizens want a strong USD making imported products cheaper but US producers of goods and services to foreign countries are ok accepting a weaker dollar if most of its goods and services are exported to foreign countries making exported goods relatively cheaper and driving demand higher to their foreign consumers. As for what impacts currency valuation, which as we have seen also influences crude oil prices, refer to this excellent article about currency valuation drivers. 4

5 WTI Crude Price Increase Determinants The charts and graph illustrate in simple terms how the price of oil increased from Nov 2000 to Jun The green bar represents the weakening dollar impact to price of $22/bbl or 45% of the price increase. The blue bar represents other variables that impact crude oil price such as the cost to extract the resource from the ground, supply and demand, and political tension. Of course, there are layers on layers here. As the linked WSJ article points out, the dollar's worth is based on a hopelessly complex web of shifting and interlocking factors, including trade balances, government spending, interest rates, inflation and economic growth. Those are the factors that you will see referenced when reading articles about why forex rates are behaving the way they are. Two questions posed were why does the dollar/crude price relationship exist and and are there lurking variables that explain the increase in oil prices other than dollar relative strength. The reason crude prices rise with a weakness of the dollar has been explained. And yes, there are other factors that increase crude oil in USD. What we really have concluded is that in a time of a weakening USD (and thus increasing crude oil prices), investing in companies selling crude oil serves as a partial hedge. And if you like the investment thesis of a particular company, all the better. 5

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