Thursday, March 20, 2008

Oil Prices Plunge

Oil prices plunged today on news of a strengthening dollar and weak demand.

NEW YORK ( -- Oil prices experienced the sharpest plunge in 17 years on Wednesday, driven down by weakening demand and a stronger dollar.

U.S. light crude for April delivery fell $4.94 a barrel to settle at $104.48 on the New York Mercantile Exchange.

The drop in oil was the largest single-day slide in dollar terms since Jan. 17, 1991, when oil fell by a third, or $10.56, after the United States launched an attack against Iraq to begin the first Gulf War.

In percentage terms, oil fell 4.51% on Wednesday - the biggest drop by that measure since August.
Oil may have hit a peak. We shall see.

What I want to know is how declining interest rates (bigger money supply) lead to a strengthening of the dollar. Something doesn't add up.


Neil said...

I understand your confusion, it's a slippery concept to hold in your head. Luckily, I earn my living holding slippery concepts in my head. (Few concepts are more slippery than the magnetic flux in a doubly-fed induction motor--but I digress.)

The value of the dollar relative to other currencies is a supply-demand equation. The Fed can decrease the dollar's value by increasing the money supply, but investors can increase demand for the dollar by investing in U.S. equities and securities.

Things have been confusing lately, so I have been testing three hypotheses against reality for the last several months, and as of this week only one has survived. A brief description goes like this: The dollar has been declining because the subprime mortgage crisis scared the bejeezus out of the Europeans and Arabs (and Chinese, to some extent which is unknown to me) who hold an awful lot of securitized paper issued by U.S. banks. They have been fearful of a systemic crash of the market for U.S. securities, and so have been selling, or simply not buying, the securities (mortgage-backed and otherwise) issued by U.S. banks. They've been selling their dollars in order to invest elsewhere. This has destroyed demand for the dollar.

The Fed's reduction in the short-term Fed Funds rate (which only money-center banks can borrow at), as well as the other bail-out actions, is basically a gift to the big banks. They borrow money at short-term rates, and lend at long-term rates, making their profit off the difference between the two rates. The bigger the difference between the two rates, the bigger their profit.

More bank profits, greater bank safety, more demand for U.S. securities by fearful furriners, and Blammo! a higher dollar.

It pretty much is that simple.

M. Simon said...

Magnetic flux in a doubly fed induction motor I understand.

Thanks for explaining the rest.

I do fear that it is a short term move for expediency which will cause long term harm.

Neil said...

Everything the Fed does is a short-term action which causes long-term problems. It is arguable that the current crisis was caused by 1)the massive surge in liquidity Greenspan pumped into the system after 9/11, and 2)keeping rates too high for too long over the last few years in an attempt to clean up after action 1).

Unfortunately, I have not yet heard anyone describe a better way in detail. Speaking as a former gold enthusiast, the gold standard didn't work any better.

M. Simon said...

I used to be a gold bug too.

I concur.