A Brief History of Oil’s Value

History is repeating itself today as low oil prices force collaboration between OPEC and non-OPEC producers. An historical analysis of the real global price of oil shows that OPEC will push up prices when the value of oil drops, as in 1995, or work with non-OPEC countries to defend a value floor, as in 1999 and in 2016 until the present. This value floor is defined by times when OPEC advocated abandoning the U.S. dollar as a basis for pricing oil, or when OPEC and non-OPEC countries collaborated.

Oil has been almost exclusively traded in U.S. dollars throughout its history. The RGP of oil is the price corrected for both inflation and for variations in the U.S. dollar’s value on global currency markets. It is a superior data series for historical analysis because it approximates oil’s value with respect to OPEC. An historical analysis of the RGP of oil does not replace a supply-demand analysis, but past events in the history of oil’s value provide a context for today’s tumult.

Economists typically show two price series for a commodity: nominal and real prices (see figure 1). The nominal price is the price in dollars of the day, or DOD; it is not corrected for anything. The real price is corrected for inflation, usually using the U.S. consumer price index. Real prices are intended to show value by removing the distortions of inflation. Key oil industry publications use a real price data series to reconstruct the value of oil back to Drake’s well (for example, BP’s Statistical Review of World Energy, 2017). Unfortunately, these real price curves do not represent the value of this global commodity because they do not capture changes in the value of the U.S. dollar since the Bretton Woods system ended in 1971, and the consequent effects on OPEC’s purchasing power.

Bretton Woods System

The changes in the value of the U.S. dollar are shown in figure 2. The U.S. dollar was stable in the 1960s because of the Bretton Woods system. The Bretton Woods agreement was instituted by the Allies in 1944 to establish a post-war system for currency exchanges. Member nations agreed to fix their currency to a 1-percent trading range. Foreign central banks could convert U.S. dollars to gold at $35 per ounce at the “gold window.” The U.S. dollar became the world’s reserve currency – “as good as gold.” This system worked great after World War II when Europe had little gold and lots of greenbacks from the Marshall Plan.

By the early 1960s, the United States had more dollars in circulation than it had gold reserves to back them. Attempts to “defend the dollar” failed. Increasing deficit spending on the Vietnam War and President Johnson’s “Great Society” program further pushed down the unofficial value of the dollar. Gold rose to $40 per ounce or more on the streets of Europe. European central banks rushed to redeem U.S. dollars for gold at the official rate of $35 per ounce, resulting in a run on Ft. Knox. On Aug. 15, 1971, President Nixon closed the “gold window,” ending the Bretton Woods system. The Smithsonian Agreement of 1971 attempted to rescue the Bretton Woods system but failed. By 1973, the greenback’s value had dropped 21 percent after two devaluations in only 14 months. Since then, the U.S. dollar’s value has floated on global currency markets. It has gained or lost as much 60 percent over a few years.

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History is repeating itself today as low oil prices force collaboration between OPEC and non-OPEC producers. An historical analysis of the real global price of oil shows that OPEC will push up prices when the value of oil drops, as in 1995, or work with non-OPEC countries to defend a value floor, as in 1999 and in 2016 until the present. This value floor is defined by times when OPEC advocated abandoning the U.S. dollar as a basis for pricing oil, or when OPEC and non-OPEC countries collaborated.

Oil has been almost exclusively traded in U.S. dollars throughout its history. The RGP of oil is the price corrected for both inflation and for variations in the U.S. dollar’s value on global currency markets. It is a superior data series for historical analysis because it approximates oil’s value with respect to OPEC. An historical analysis of the RGP of oil does not replace a supply-demand analysis, but past events in the history of oil’s value provide a context for today’s tumult.

Economists typically show two price series for a commodity: nominal and real prices (see figure 1). The nominal price is the price in dollars of the day, or DOD; it is not corrected for anything. The real price is corrected for inflation, usually using the U.S. consumer price index. Real prices are intended to show value by removing the distortions of inflation. Key oil industry publications use a real price data series to reconstruct the value of oil back to Drake’s well (for example, BP’s Statistical Review of World Energy, 2017). Unfortunately, these real price curves do not represent the value of this global commodity because they do not capture changes in the value of the U.S. dollar since the Bretton Woods system ended in 1971, and the consequent effects on OPEC’s purchasing power.

Bretton Woods System

The changes in the value of the U.S. dollar are shown in figure 2. The U.S. dollar was stable in the 1960s because of the Bretton Woods system. The Bretton Woods agreement was instituted by the Allies in 1944 to establish a post-war system for currency exchanges. Member nations agreed to fix their currency to a 1-percent trading range. Foreign central banks could convert U.S. dollars to gold at $35 per ounce at the “gold window.” The U.S. dollar became the world’s reserve currency – “as good as gold.” This system worked great after World War II when Europe had little gold and lots of greenbacks from the Marshall Plan.

By the early 1960s, the United States had more dollars in circulation than it had gold reserves to back them. Attempts to “defend the dollar” failed. Increasing deficit spending on the Vietnam War and President Johnson’s “Great Society” program further pushed down the unofficial value of the dollar. Gold rose to $40 per ounce or more on the streets of Europe. European central banks rushed to redeem U.S. dollars for gold at the official rate of $35 per ounce, resulting in a run on Ft. Knox. On Aug. 15, 1971, President Nixon closed the “gold window,” ending the Bretton Woods system. The Smithsonian Agreement of 1971 attempted to rescue the Bretton Woods system but failed. By 1973, the greenback’s value had dropped 21 percent after two devaluations in only 14 months. Since then, the U.S. dollar’s value has floated on global currency markets. It has gained or lost as much 60 percent over a few years.

OPEC Defends a Value Floor

By late 1973, the price of gold had tripled and the price of corn and wheat had doubled. But nominal oil prices were still at $3.50 per barrel (DOD). The back-to-back devaluations in the greenback were a “dollar shock” to OPEC. OPEC hit a “painful threshold” (see point A, figure 3) of very low value for its commodity; below $18 per barrel in a RGP analysis. Supply and demand were in tight balance. So OPEC raised nominal oil prices to $10 per barrel (DOD) to regain purchasing power.

Much has been written on the geopolitics and OPEC’s use of “the oil weapon” to explain the near tripling of nominal oil prices by 1975. Certainly, the West’s support of Israel during the Yom Kippur War angered Arab nations. But OPEC’s greater and longer-standing frustration was with the declining dollar, which predated the war. Before OPEC’s Dec. 12, 1970 meeting, OPEC resolved that the reference prices for OPEC oil should be adjusted to maintain its purchasing power. In March 1973, OPEC sought an amendment to the January 1972 Geneva Agreement because of the falling value of the greenback.

Thus, the price increases of the early 1970s were simply OPEC regaining purchasing power after years of inflation and a dramatic devaluation of the U.S. dollar. OPEC over-corrected nominal prices by 1980, and oil was over-valued. The extreme spike in the dollar’s value in the mid-1980s preserved OPEC purchasing power even as nominal prices fell.

Greenback Sinks, OPEC Feels the Pain

By 1995, the RGP of oil slid back to the value floor defined in 1973. From 1990 to 1995, the nominal price of oil fell from $25 to $17 per barrel (DOD). The U.S. dollar’s value fell 17 percent over the same time. Oil was back to its 1973 value floor of $18 per barrel (RGP). OPEC felt the pain of lost purchasing power.

OPEC’s loss in purchasing power was worse than in 1973. Important OPEC countries obtained 60-90 percent of their revenue from oil sales. By 1995, many of OPEC’s countries had become modern economies with a burgeoning middle class. For example, in 1973, OPEC countries consumed about 1 million b/d. By 1995, OPEC countries were consuming 5 million b/d, one-fifth of their own production quota; evidence of a consumer middle class.

OPEC’s response in 1995 was to openly call for abandoning the U.S. dollar as a basis for pricing oil. Various alternative pricing schemes were put forward. The schemes were dropped because they were too cumbersome. The mid-1990s were a difficult time for OPEC cohesion. At their June 1995 meeting, OPEC members agreed to keep production flat. The RGP of oil returned to the middle of the post-1986 trading range.

Non-OPEC Defends Oil’s Value

In 1998, the RGP of oil fell below OPEC’s value floor when the nominal price fell to $11 per barrel (DOD). The 1998-99 collapse was caused by oversupply. OPEC had raised its production quota just before a recession hit Asia. This caused a sharp slump in demand and prices fell. This collapse was important because it demonstrates that non-OPEC countries also felt the pain from oil’s low value. Many non-OPEC countries sent representatives to “observe” OPEC meetings. By March 1999, non-OPEC countries Norway and Mexico brokered an agreement with Venezuela that led to OPEC production cuts, and cuts by non-members Norway, Mexico and Russia. Nominal oil prices rose to about $24 per barrel (DOD), or $30 per barrel (RGP), thereby preserving OPEC’s purchasing power. By 2000, oil’s value was in the middle of the post-1986 trading range.

The lesson is clear: when oil hits a value floor, OPEC intervenes; when oil’s value drops below the value floor, everybody intervenes. These events presaged the events of today.

Oil-Dollar Inverse Relation Born

The greenback dropped 25 percent from 2000 to 2005. By 2005, OPEC’s surplus capacity fell to less than 1 million b/d. With supply and demand in tight balance, OPEC (and day-traders in commodity “pits”) could make almost daily adjustments to nominal prices to offset changes in the U.S. dollar’s value. The oil-dollar inverse relationship commonly known today was born. The 14-percent decline in the value of the dollar from 2005 to 2011 was more than offset by increases in nominal prices. Oil became over-valued. Oil’s value was significantly below the real price and lower than the value during the 1980s boom.

American Over-Supply

In 2014, oversupply put downward pressure on oil prices. In February, Iraq’s oil production increased by 520 thousand b/d. America’s production climbed to 8.5 million b/d, up incrementally 3.3 million b/d. In the 1970s, the world had to deal with OPEC “oil price shocks.” Now, OPEC had to deal with American “oil supply shocks.” OPEC held production flat. Rising American production displaced OPEC oil. The sophistry of “Peak Oil” was forever dead.

The 18-percent rise in value of the greenback from 2015 to 2017 helped OPEC retain purchasing power even as nominal oil prices dropped. For almost two years, OPEC kept output steady. Drilling in many shale plays slowed, and some U.S. companies filed for bankruptcy. But American entrepreneurs innovated and adapted. U.S. production increased.

New Value Floor

In 2016, OPEC and non-OPEC oil producers realized they needed to cut production. Nominal oil prices had tested $30 in February and rose to $49 per barrel (DOD) by October. Both OPEC and non-OPEC countries felt the pain and acted to defend a value floor. In October 2016, Russian President Vladimir Putin announced support for cutting output. The new value floor is about $28 per barrel RGP. The higher value floor ($28 vs $18) might be because OPEC+ countries’ social and military costs had re-set to a higher cost structure; or because OPEC+ countries had a price expectation bias greater than market fundamentals would support.

Today

Oil prices have collapsed in the 2020 coronavirus pandemic. This collapse was triggered by a profound drop in global oil demand concurrent with over-production by certain OPEC+ members, and U.S. oil production peaking at 13.1 million b/d.

In late April, May oil contracts went negative. At the time of this writing (early May), WTI spot price is $23.50 per barrel (DOD). Oil’s value is below the $28 (RGP) value floor and hit the $18 (RGP) value floor. Nominal oil at $23.50 (DOD) converts to $17.30 per barrel in a RGP analysis. Oil’s value today is the same as it was in 1995.

Again, the world intervened to defend oil’s value. On April 12, OPEC+ agreed to cut production by 9.7 million b/d for May and June. After June, OPEC+ cuts will drop to 7.6 million b/d for 2020, then drop to 5.6 million b/d until April 2022. Bloomberg News reports, “On top of OPEC+ cuts, oil producers in the G-20 will contribute output reductions. Production declines due to the effects of low prices in the U.S., Brazil and Canada will be counted, deepening the global supply reduction by 3.7 million b/d, with other G-20 states contributing 1.3 million.” Goldman Sachs estimates global oil demand will have fallen by 19 million b/d for May.

Assuming the U.S. dollar’s value remains constant, nominal oil prices need to recover to $55 per barrel (DOD) for OPEC+ members to regain the purchasing power at the middle of the post-2014 RGP trading range, or about $40 per barrel (RGP). Considering the massive oil supplies in storage and global production capacity, what OPEC+ wants, and what the oil market dictates, might prove to be different.