Ole Gunnar Austvik: http://www.kaldor.no/energy e-mail: [email protected]

OPEC Review no. 4 December 1987. ISSN no. 0277-0180. http://www.opec.org/

Oil Prices and the Dollar Dilemma When the exchange rate of the U.S. dollar fluctuates, a disequilibrium is created in the market for crude oil. This will be reflected in altered demand for crude oil and/or in an altered oil prices. The partial equilibrium model in this paper illustrates that an appreciation of the dollar leads to a lower oil price denominated in dollars. The effect will be smaller the greater the U.S.'s share of the oil market, the more elastic demand is in the U.S. and the more inelastic demand is in other countries.

TABLE OF CONTENTS Introduction ............................................................................................................................................................... 2 1. The U.S. Dollar and the Market for Crude Oil ................................................................................................. 2 1.1 The Denomination of Oil Prices in U.S. Dollars and Western European Currencies 1980-84 ............ 3 1.2 Oil Imports to the OECD Area ................................................................................................................ 3 2. Crude Oil Prices in Purchasing Countries with Different National Currencies ........................................... 4 2.1 The Demand for Crude Oil in Country i ................................................................................................. 5 2.2 The Relations Between Oil Prices in Country A and Country B. ........................................................ 6 2.3 Possible Distributions of Crude Oil Supply Between Country A and Country B. ............................. 7 2.4 Analytical Model for Oil Prices and Exchange Rates ............................................................................ 8 2.5 Graphical Model for Oil Prices and Exchange Rates .......................................................................... 10 3. Closing Comments ............................................................................................................................................... 13 References ................................................................................................................................................................. 14 Appendix: Can Oil Be Priced In Currencies Other Than the U.S. Dollars ? …….. ........................................... 15 Sammendrag på norsk ............................................................................................................................................. 18 Summary in English ................................................................................................................................................. 18

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Introduction This paper addresses the impact of changes in exchange rates of the U.S. dollar on the oil market. The discussion relies on a partial equilibrium model to illustrate how disequilibrium in the oil market occurs, and how a new equili1

brium may be reached, when dollar exchange rates fluctuate.

Oil prices are influenced by a number of economic, political and psychological factors. In order to determine how exchange rates make an impact, it is useful to rely upon a model based on partial analysis. This method enables us to examine the impact of exchange rate fluctuations on oil prices independently from other variables. Thus, in the model presented in this paper we exclude variables such as how fluctuations in the exchange rates affect macroeconomic conditions and subsequently the demand for oil, effects of the substitution of other energy sources either globally or regionally, the fact that a number of countries have large debts and assets held in dollars, the fiscal policy each country applies to changes in currency rates, and other economic and political factors than exchange rates which have an impact on the level and structure of demand, supply and the price of crude oil. From our analyzes we also exclude repercutions back to the currency markets from changes in oil prices.

The development of oil prices in different currencies in recent years is described in Section 1. In particular, this discussion focuses on the differences between oil price denominated in European currencies as opposed to the oil price in terms of U.S.dollars. In Section 2, a partial equilibrium model of the oil market is introduced to illustrate how oil prices both in U.S. dollars and other currencies, react to fluctuations in exchange rates. Some concluding comments are made in Section 3.

1. The U.S. Dollar and the Market for Crude Oil

Most primary commodities are priced in American dollars. Trade, however, goes to a large extent between countries that do not have the dollar as their national currency. Thus, the U.S. dollar is a common converting unit for all actors in the market. However, the price faced by each buyer and seller in the market is the price of the commodity determined in dollars multiplied by the country's exchange rate against the U.S. dollar (number of units of national currency needed to buy one U.S. dollar).

In the first half of the 1980's, the dollar price of oil decreased. However, the rise in the value of the dollar against most other currencies led to an increase in oil prices in most other currencies. Depending on the degree to which each national currency was depreciated against the U.S. dollar, the developments in the oil prices differed remarkably. In Western Europe, oil prices increased by approximately 50 per cent in the period 1980-1984. At the

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I am very grateful to Mr. Rolf Golombek at the Department of Economics (University of Oslo) for his helpful comments during the development of the model and to an anonymous referee for comments on an earlier version of the paper. I am also very grateful to Miss. Christine Ingebritsen who has worked through the English text carefully.

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same time, prices in U.S. dollars decreased in the range of 15 to 20 per cent. Thus, European oil prices increased more than 70 per cent in relation to prices in U.S. currency in this period. This development is shown in figure 1.1:

1.1 The Denomination of Oil Prices in U.S. Dollars and Western European Currencies 1980-84 1980 = 100

Will be included soon------

Source : IEA/OECD

1.2 Oil Imports to the OECD Area 1980-84 Million tonnes ----------------------------------------------------------1980 1124 - “ 1981 985 - " 1982 878 - " 1983 824 - " 1984 846 - " - 100.0 % Of which (1984): Western Europe 436 - " - 51.5 % U.S.A. 207 - " - 24.5 % Japan 182 - " - 21.5 % Others 21 - " - 2.5 % ---------------------------------------------------------Source : IEA/OECD

Further, the consumption of oil strongly decreased in this period. As illustrated in the table above, OECD oil imports decreased by 25 per cent (approximately 278 million tonnes) in the 1980-84 period. This decrease was a result from a number of factors, such as substitution to other primary energy sources, lower economic growth, increased energy efficiency etc. However, the fact that three quarters of total imports to the OECD area go to

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countries with national currencies other than the U.S. dollar, raises some additional questions to this paper: Does the different patterns of development of national oil prices (caused by exchange rate fluctuation) have an impact on total consumption of oil? What impact does the size of the U.S. market share have on the stability of the oil price denominated in U.S. dollars?

To take a closer look at some of these problems we shall consider a partial equilibrium model illustrating the relationship between fluctuations in the currency market on oil prices.

2. Crude Oil Prices in Purchasing Countries with Different National Currencies

Our world consist in the model of only two countries, Country A and Country B; the U.S. is Country B and "rest of the world" is Country A. The demand for crude oil in each country (qi, i = A and B) can be expressed as a function of the price (pi) denominated in their respective national currencies.

qA = f(pA), where f' < 0 qB = g(pB), where g' < 0

The demand for crude oil is assumed to fall with increasing price. For any given price the demand in each country is determined:

2.1 The demand for crude oil in country i pi

pi1

qi qi1

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For country A the demand curve will be the aggregate of each of the individual countries in the "rest of the world"'s 2

national demand curves for crude oil.

The difference between the two countries' national prices is represented by the exchange rate between their currencies:

pA = VA * pB

VA is the number of units of Country A's currency per unit of Country B's currency (i.e. the number of German 3

marks pr. U.S. dollar). The price of crude oil in Country A's currency fluctuates according to changes in the currency rate, at a given price of oil in Country B's currency. Thus, the relationship between the two oil prices can be expressed as a ray from the origin with the two oil prices on the axes. The initial rate is illustrated in the figure 1

below by the slope of the ray VA . For any price in Country B's currency, there is a corresponding price in Country A's currency. The difference results from the exchange rate.

2.2 The relations between oil prices in country A and country B pA pA2 = VA2 * pB

pA1 = VA1 * pB

pB

2

We consider taxation levels on petroleum and other internal factors in the two countries to be constant. Fluctuating exchange rates will also alter the prices of all goods paid in dollars. This will give contribution to substitution between dollar paid goods and goods paid in other currencies. The nations national incomes and assets will change as a result of the altered exchange rates as well. These substitution and income effects are unsure in direction and strength and are excluded in this analyzes. 3 In fact, Country A's currency (the world outside the U.S.), will be a currency basket where all individual countries' dollar exchange rates are included. The weights given to each currency could i.e. be each nation's import share of crude oil.

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If the currency of Country B is appreciated, Country A has to pay more units of its national currency per unit of 1

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Country B's currency, and the slope of the ray will change from VA to VA . Now Country A has to pay more per barrel of oil than before, at a given price of oil determined in Country B's currency, pB (U.S. dollars). In the figure 1

above this is expressed by an upward turn of the ray, and oil prices in Country A's currency will change from PA to 2

2

1

PA , where PA > PA . The currency of Country A is then de facto devaluated; either through an administered devaluation of the currency in Country A, an administered appreciation of the currency in Country B, or a change in the exchange rate between the currencies caused by other forces in the market.

We assume that the actual purchase of oil by the two countries equals the total supply of oil, Q. Thus, the total supply of oil is given in this model. _ qA + qB = Q Graphically this equation can be illuminated as in the figure below:

2.3 Possible distributions of crude oil supply between country A and country B qB

______

Q

45o ______

qA

Q

The supply is assumed to be totally inelastic and will not be influenced by changes in the price. Thus, in our partial equilibrium model, a certain level of demand in the one country directly determines the demand in the other. This is, of course, a simplification done because it is useful for analyzing the problem at hand. However, to include supply changes in this pure economic model we would have to assume that, in one way or another, the supply side would react unique to price changes. Experts disagree how oil supply reacts to changes in oil prices. Some experts even claims that prices are only a minor factor in the determination of crude oil supply; it is political factors that determine the supply of crude oil. Thus, as a pure price-quantity scheme seems to be too unsure and/or too simple to

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describe supply side behavior, we exclude this discussion by considering supply exogenously in our model. However, we shall discuss some effects on our results if we modify this assumption in Section 3.

The equations we have provided outline (1) how demand for oil in each Country varies with respect to national prices, (2) the relationship between national prices and (3) that total consumption equals total supply:

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For a more detailed discussion of using economic and political approaches to analyze the oil market, and how this can be included in theory on the formation of crude oil prices, see i.e. Austvik 1986.

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2.4 Analytical Model for Oil Prices and Exchange Rates

2.4.1

qA = f(pA)

2.4.2

qB = g(pB)

2.4.3

pA = VA * pB

2.4.4

qA + qB = Q

The system consists of 4 equations and 6 variables (pA, pB, qA, QB, VA and Q). We assume Q to be exogenously determined in the model (the supply is kept constant), thus changes in the system are dependent upon the determination of the exchange rate.

Differentiating 2.4.1-4 gives:

2.4.5 dqA = f' * dpA

where f' < 0

2.4.6 dqB = g' * dpB

where g' < 0

2.4.7 dpA = VA * dpB + pB * dVA 2.4.8 dqA + dqB = 0

Reorganizing 2.4.5-8 gives the following results from altering the exchange rate (appreciating the dollar):

2.4.9

dpA g' * pB ----- = ---------------- > 0 g' + f' * VA dVA

The price of crude in Country A increases ; An appreciation of the dollar results in an increase in oil prices outside of the U.S.

'

2.4.10 dVA

dqA f * g' * pB ----- = --------------g' + f' * VA

< 0

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The increase in price in Country A implies a decrease in demand in that country. An appreciation of the dollar in relation to other oil importers currencies cause for an decrease in oil demand outside of the U.S.

'

2.4.11

dpB - f * pB ----- = --------------- < 0 dVA g' + f' * VA

An equilibrium in our model implies a decrease in Country B's price. An appreciation of the dollar in relation to other oil importers currencies causes the crude oil price in dollars to decrease.

'

dqA f * g' * pB dqB 2.4.12 ----- = - ----- = - --------------- > 0 dVA g' + f' * VA dVA

The demand for oil in Country B increases. An appreciation of the dollar towards other oil importers currencies causes the demand for oil in U.S. to increase.

Graphically 2.4.1-4 can be illustrated as in the figure below:

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2.5 Graphical model for oil prices and exchange rates qB II

I

____

Q

F New equilibrium E

Initial equilibrium

pB

____

Q

qA

VA1

III

VA2

IV pA

In the first quadrant we illustrate the distribution of total supply of crude oil (2.3), in the second quadrant the demand for crude oil in Country B, in the fourth quadrant demand for oil in Country A (both 2.1) and in the third i

quadrant the rays VA (i=1,2) illustrate the relationship between the prices in the two countries (2.2) with two different exchange rates between them.

Initially equilibrium is at point E, where demand is distributed between the countries at the prevailing prices and exchange rates. This initial equilibrium is illustrated by the thicker broken lines.

If the currency of Country A de facto is devaluated, the relationship between the national oil prices is affected. This 1

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is expressed by a turn of the ray from VA to VA in the third quadrant.

After the devaluation the initial distribution of crude oil no longer represents an equilibrium since it is not consistent with the new relationship between the prices in the two countries. The new equilibrium is at point F, where the oil price in Country A has increased. This implies that demand decreases in that country. Accordingly, the price in Country B has decreased, as the demand for oil in country A has increased. Thus, a switch in oil consumption from Country A in favour of Country B has taken place.

In this model the quantity effects of a devaluation will be of the same size in both countries, with opposite signs. The

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decline in consumption in one country, will be met by a corresponding rise in consumption in the other country.

Thus, the numerical value of the elasticity of demand in each of the countries with respect to the exchange rate can be expressed as:

2.5.1

El qi VA

dqi VA = ------ * --- = dVA

pi

'

f * g' * pB VA ---------------- * ---g' + f' * VA

(i=A,B)

pi

This elasticity give an expression of how many per cent qi will change when VA changes 1 per cent. It illustrates that a low numerical value of the demand derivatives with respect to prices, f' and g', also correspond to low numerical value of the demand elasticity with respect to exchange rates. Since demand elasticities have the same sign as the corresponding demand derivatives but give an expression of relative as apposed to absolute changes, we can conclude from this that the transfer effect in quantity of a devaluation of one of the currencies is less the more inelastic the demand is with respect to national prices. The demand elasticity with respect to prices in one of the countries will (in this model) have an equally strong impact on the demand in the other country as the demand elasticities (with respect to prices) in the country itself.

However, an appreciation of the dollar will not necessarily result in a total redistribution of volume of oil between U.S. and other importing countries. Because of a rigid production structure and other features unique to the U.S., there will be some limitations on how much oil the nation can absorb in the short run, independent of price. In addition to the downward pressure on the dollar price of oil in the adjustment towards a new equilibrium, an 6

appreciation of the dollar would probably result in decreasing the total quantity demanded as well.

The elasticities of the national prices with respect to the exchange rate between the two countries' currencies can be expressed as:

El pi VA

2.5.2

VA dpi = ----- * ---dVA

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PA

>0

if i = A