The Role of Oil Prices in Global Financial Markets

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There is, to those of a somewhat romantic bent, an inherent beauty in financial markets.

Even just simple supply and demand has an appealing logic. As demand for a product increases, the price goes up, prompting an increase in supply, which in turn brings the price back down. When you look at the flow of money between countries and asset classes in a global sense, that tendency toward equilibrium becomes much more complex, but it is still the driving force of markets, with the same inherent self-correcting tendencies. Foreign exchange rates, interest rates in different countries, and stock prices around the world are all part of this complex dance, but in the modern, energy dependent world, the price of oil is arguably the most influential variable.

Oil, despite several different benchmarks such as Brent and WTI, is a commodity traded on a global market. While the value of a country's currency, or the interest rate its government must pay to borrow, can affect economic conditions in that country, fluctuations in the oil price affect us all. Whether we like it or not, oil is still the principal source of the world's energy, and pricing of the two next largest sources, coal and natural gas, are heavily influenced by the price of the black stuff. According to The International Energy Agency (IEA), those three accounted for over 80 percent of the world's energy supply in 2012. Lower oil prices, therefore, give a boost to the global economy, while a rapid rise can strangle growth.

The wide variations in the production cost of oil make it very sensitive to price swings. When costs vary as much as they do, from an average cost per barrel in the Middle East of $16.68 per barrel to offshore American oil that costs $51.60 per barrel to extract (again using IEA numbers), many wells can quickly become uneconomical when prices are volatile, leading to supply dropping. If demand and supply were the only thing that influenced the price, that would be manageable, but they are not.

Oil is priced in U.S. dollars, so the relative strength of the dollar also impacts the price. If the dollar gains in strength, it gains against everything, including commodities.

To simplify, if, as a starting point, one barrel of oil could be exchanged for $100 and then the dollar doubles in overall value, it would take two barrels to buy the same number of dollars. Dollars would have doubled in value and therefore the price of oil, as expressed in dollars, would halve.

The dollar's strength or weakness is influenced by many things, but one of the biggest is its status as a "safe haven" currency. When the economic outlook looks to be worsening, money around the world is used to buy the relative safety of U.S. dollars, and this is where the self-correcting beauty of markets comes in.

As the dollar strengthens, oil prices fall. Lower oil prices push down the cost of manufacturing and transporting goods, which in turn improves economic prospects around the globe. The reaction to worry has, at least in part, helped to alleviate that worry.

Increasing supply as the shale boom continues apace, combined with worries about global growth and the resultant strong dollar, can explain why, even with global tensions increasing, the price of oil has been falling. This is bad news for oil companies and their stockholders, but in the long run it will give a boost to the global economy.

When that happens, the whole process will reverse and the "invisible hand" that guides financial market will once again have done its job.

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