In this article, we explained currency fluctuations, oil profits, what causes currency fluctuations and how currency fluctuations affect oil profits.
Definition
Currency fluctuations refer to the constant changes in the value of one currency relative to another, driven by factors like supply and demand, economic conditions, interest rates, inflation, political stability, and speculation. These shifts significantly impact global economics, international trade, and investment, affecting businesses and individuals engaged in cross-border transactions.
Profit oil is the portion of crude oil production that is divided between participating parties (oil companies) and the host government after deducting cost oil and royalties. It represents the revenue available for distribution after covering operational expenses and government revenue share.
Factors Causing Currency Fluctuations:
Inflation:
Higher inflation generally reduces a currency’s purchasing power and attractiveness, leading to depreciation, while lower inflation supports a stronger currency.
Interest Rates:
Central banks’ interest rate decisions significantly impact currency values; higher rates attract foreign investment, increasing demand and strengthening the currency, while lower rates can lead to capital outflow and depreciation.
Economic Performance:
Strong economic indicators like high GDP growth and low unemployment boost investor confidence, potentially leading to a stronger currency. Conversely, recessions and poor economic performance can weaken a currency.
Political Stability:
A stable political environment is attractive to investors, supporting a stronger currency, while political uncertainty or instability can cause investors to move capital, leading to currency depreciation.
Government Debt:
High levels of national debt can lead to a currency’s value falling, as central banks might increase the money supply to manage the debt.
Speculation:
Traders’ perceptions and speculative activities can cause significant short-term fluctuations in exchange rates as they buy or sell currencies based on anticipated future movements.
Terms of Trade:
The ratio of a country’s export prices to its import prices influences its currency’s value.
Current Account Deficits/Surpluses:
These reflect a country’s balance of trade and its overall balance of payments, impacting demand for its currency.
Government Intervention:
Central banks can directly intervene in the foreign exchange market by buying or selling their own or foreign currencies to influence exchange rates.
How Currency Fluctuations Affect Oil Profits from Different Perspectives:
- Impact on Oil Prices (The “Petrodollar” Effect)
The strong historical link between the U.S. dollar and oil prices is often referred to as the “petrodollar” system, established in the 1970s. Here’s how it generally works:
Stronger U.S. Dollar:
Higher Cost for Non-Dollar Buyers: When the USD strengthens against other currencies, oil becomes more expensive for countries that use other currencies (e.g., Euro, Yen, Rupee) to purchase it. This is because they need to spend more of their local currency to acquire the same amount of USD, which is then used to buy oil.
Reduced Demand: This increased cost can lead to a decrease in oil demand from major importing nations outside the US. Lower demand, all else being equal, tends to put downward pressure on the dollar price of oil.
Impact on Oil Prices: Historically, a stronger dollar has often correlated with lower oil prices. This is a key reason why oil prices and the dollar often move in opposite directions (a negative correlation).
Lower Cost for Non-Dollar Buyers: Conversely, when the USD weakens, oil becomes relatively cheaper for buyers using other currencies. They need fewer units of their local currency to buy the same amount of USD for oil purchases.
Increased Demand: This affordability can stimulate oil demand from importing countries. Higher demand, all else being equal, tends to exert upward pressure on the dollar price of oil.
Impact on Oil Prices: Historically, a weaker dollar has often correlated with higher oil prices.
Important Nuance: While the inverse relationship (stronger dollar = lower oil prices; weaker dollar = higher oil prices) has been a dominant historical trend, recent studies suggest this correlation can shift due to other factors like global risk aversion, market financialization, and the US emerging as a major oil exporter. However, the fundamental mechanism of how currency value affects purchasing power for dollar-denominated goods remains true.
- Impact on Oil Producers’ Profits
For oil-producing companies, currency fluctuations primarily affect their revenues and costs
Conversion to Local Currency: If an oil company’s operational costs and shareholder dividends are primarily in a non-USD local currency (e.g., a Nigerian Naira, Saudi Riyal, Norwegian Krone), they convert their USD earnings back into that local currency.
Stronger U.S. Dollar: This is generally favorable for oil producers operating in non-dollar economies. When they convert their USD revenue, they receive more units of their local currency, boosting their top-line revenue and profitability when expressed in local terms.
Weak U.S. Dollar: This is generally unfavorable. When they convert their USD revenue, they receive fewer units of their local currency, which can diminish their local currency revenue and profits, even if the dollar price of oil remains stable.
Local Costs: Many operational costs (labor, local services, some equipment) are incurred in the local currency.
Imported Costs: However, a significant portion of capital expenditures (e.g., drilling equipment, specialized technology, spare parts) and some operational supplies are imported and often priced in USD or other major foreign currencies.
Stronger U.S. Dollar: This makes imported equipment and services cheaper when paid for with local currency, which can reduce their operational expenditure and improve profitability.
Weak U.S. Dollar: This makes imported goods and services more expensive in local currency terms, increasing operational costs and potentially squeezing profit margins.
Net Effect for Producers: The overall impact on a producer’s profit depends on the balance between these revenue and cost effects. For many major oil-exporting nations and their national oil companies, a stronger USD (assuming the dollar price of oil doesn’t crash) can often boost their local currency revenues and fiscal budgets, which are heavily reliant on oil exports.
- Impact on Oil Consumers’ Profits (and Economies)
For countries and companies that import oil, currency fluctuations significantly influence their purchasing costs:
Purchasing Costs:
Non-Dollar Currency: Oil-importing nations and their industries (e.g., manufacturing, transportation, refining) pay for oil in USD using their local currency reserves.
Stronger U.S. Dollar: This is unfavorable for oil importers. They need to spend more of their local currency to buy the same amount of USD, making imported oil more expensive. This translates to higher costs for businesses (e.g., airlines, trucking companies, petrochemicals) and higher fuel prices for consumers, potentially leading to inflation and dampening economic growth.
Weak U.S. Dollar: This is favorable. They need to spend less of their local currency to buy the same amount of USD, making imported oil cheaper. This can reduce operational costs for businesses, potentially lowering inflation and stimulating economic activity.
Profitability of Industries:
Industries heavily reliant on oil as a feedstock or fuel (e.g., transportation, manufacturing, plastics) will see their profit margins directly impacted by these currency-driven shifts in oil costs. A weaker dollar often boosts these industries’ profitability by reducing their input costs.
Conclusion
Currency fluctuations play a pivotal role in shaping oil profits, especially in a globally interconnected market. Since oil is priced in U.S. dollars, any changes in exchange rates affect oil-exporting nations, oil-importing countries, and multinational oil companies in different and sometimes contradictory ways.
READ: Crisis Management in the Oil Industry