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631: The Mighty US Petrodollar - Learnings for Property Investors

12-25-2018 team

Happy Christmas. Today's Newsletter is focussed on one key topic - the mighty US dollar petrocurrency and the impact this has for property investors.

The Mighty Dollar and the House of Saud and the Big Deal: Ever since Richard Nixon took the dollar off the gold standard around 1972 the dollar has been a fiat currency. But in 1972-1974 – President Nixon along with Henry Kissinger signed up the Saudi Arabians to always trade oil in US dollars in return for military hardware and protection of the House of Saud Kingdom and family. On the odd occasion, countries after this date would challenge the US dollar by trying to trade in other currencies – but all were either invaded or sanctioned. This list includes Libya, Iran, Iraq and Russia. As soon as countries start trading oil – which is by far the biggest financially traded commodity – in anything but the mighty US dollar, then they see big problems.

Gold Standard and Dollar: In simple terms, between 1945 and 1971 the US dollar was backed by gold, but half of this gold – it dropped from ~570 million ounces to ~261 million ounces – was sold up to 1971. Then to pay for their large deficits and the Vietnam war – the US printed money at an exponential rate – with a very large step up in 2008 after the financial crash. The Chinese, Saudis and other great trading partners bought US Treasuries and US dollars to buy oil – and because of this, the US has had a strong currency, with low inflation, low interest rates and a very prosperous society with low taxes and high living standards. In simple terms, after 1971 the US dollar became a Petrocurrency backed by global oil reserves – many of these in Saudi Arabia. This partly explains why successive governments have had close relationships with Saudi Arabia – and Trump did his 180 degree U-turn after the election when presumably he learned how important Saudi was to the strength of the US dollar, military exports and US living standards. The US is able to exert huge pressure and influence over trading partners because oil is traded in US dollars – and cutting off the dollar from their economies ends up crippling these countries – because they can’t import crude oil or refine products also traded in dollars.

Dollar Was Close to Collapse: During Obama’s Presidency it looked increasingly likely that the US dollar would collapse partly because of the huge US deficits off the back of importing some 8 million bbls or oil a day – a colossal oil import bill around 2008 of some $450 billion a year. But what a difference a decade makes. First of all the US shale drillers learned how to drill horizontal wells and frac them – then produce copious quantities of natural gas by 2007. This drove natural gas prices down from around $4/mmscfd to $2/mmscfd – prices halved. Then in 2008 we had the financial crises after a melt up early 2008 just before the Beijing Olympics – and oil prices collapsed from $150/bbl to $36/bbl – but then recovered to $75/bbl by 2010 after the Fed started QE1 and QE2. Every time they announced more QE oil prices rose – a hedge against inflation. 

Shale Oil Revolution: Then the shale gas drillers had realised that they could target the oiliest parts of oil-gas fields with horizontal wells in star patterns with up to 20 fracs per well to deliver oil wells that would produce around 200-800 bbl of oil a day. The economic threshold of these wells fluctuates between around $30/bbl to $85/bbl depending in the region, efficiency of the operator and sweat spots that are drilled. The oil shale drilling then led to a massive increase in US oil production from a low of 5 million bbls/day in 2005 to 11.3 million bbls/day end 2018. This has eradicated US oil imports – and now the US is a net oil exporter – because the amount of combined oil and refined oil produces it exports is now larger than what it imports. That’s a gigantic turn-around in the last 8 years that has truly transformed the outlook for the US economy and has saved the mighty US dollar from collapse under the pressure of the gigantic deficits – in our opinion.  It has also allowed the US to be far bolder in its trade negotiations with partners like China – who they accuse of money laundering, stealing intellectual property and flooding the US with cheap subsidized imports. The Trump Presidency starting in 2017 is a far more nationalistic administration that has an “America First” policy – and are using their new oil independence, lower deficits, huge military might and the mighty Petrodollar to bully their way around the world. Anyone that threatens not to use the US dollar for oil trading will either be sanctioned (Russia, Iran) or invaded (Libya, Iraq in 2002-2005). The current Iraqi and Saudi governments are well aware of this – they want their oil reserves also backed by the US dollar and military.

Saudi – US Alliance: You can see that Saudi Arabia is treading a fine line between pleasing Trump by producing enough oil to keep prices down at the American gas pumps – and wielding their influence over OPEC to keep revenues high to improve social stability and allow government hand-outs to keep the ever increasing population happy. Remember the Saudi population is doubling every 20 years so social payments are ballooning, they have very little industry and are hugely reliance on oil exports and oil prices. You may have noticed they succeeded in reducing supplies by 1.2 million bbls/day at the OPEC meeting 6 December – also by getting Russia to help with the cuts – that saw oil prices rise from $50/bbl to $60/bbl by 10 Dec – however rising US oil inventories meant oil prices dropped back to $50/bbl by 24 Dec. OPEC is just about surviving – and may be OPEC is good for the US dollar with Saudi at the help – because it increases the chance the US will remain a strong petrocurrency. The global cartel – with government ministers controlling the oil market would be totally illegal in any country, but because its government ministers (not companies) colluding on a global scale – it is apparently legal. No-one gets arrested for attending the meetings. What it has done is increase the oil prices just enough to encourage the oil shale drillers to keep drilling hard and increase US oil output – and taking market share from OPEC. You may recall Prince Mohammed Bin Salman pulled the plug on an OPEC deal taking shape in Qatar in 2015 after oil prices had already crashed from $110/bbl in July 2014 to $50/bbl – then this decision lead to prices crashing to $29/bbl creating a fiscal crisis in the Middle East. It was calculated to destroy then US Shale Oil drilling industry – but though it was a set-back – they recovered by improving efficiencies even further – and OPEC and Saudi then gave in around 2017 and started making cuts again that then lead oil prices to rise to $80/bbl by mid 2018.

Shale Oil Increase: But of course then the shale oil drillers started going even faster and now US oil production has reached a massive 11.7 mln bbls/day as of 18 Dec 2018 – and oil prices have crashed back to $47/bbl (WTI). What this all means is that OPEC can’t really control then situation anymore and they don’t know which way to turn. Every time they cut production, Trump complains, the oil prices rise slightly then the shale oil drillers get going and take their market share even further! It must be sole destroying for OPEC – the USA and the Shale Oil drillers have clearly in our view won the day. OPECs strategy of flooding the market made little difference – and they lost about $1 Trillion of oil revenue because of it in the period since end 2014.

Property Investors: So what does all this mean for the property investor?  Overall the oil price coming down tends to help property investors a lot in that it reduces the general inflationary pressures and reduces the chances of sharp interest rate rises. This then means people are able to borrow larger amounts and this sends up asset – house prices. Low interest rates and general inflation are good for high house prices.
US Real Estate: But the dollar dominance is definitely good for the US real estate prices in that they are able to continue to borrow huge amounts of money globally to finance their lifestyles and these feeds through to higher house prices.

Sterling Exchange Rates:  For UK property investors – the US/UK Sterling and also the Euro/UK Sterling exchange rates are important – a weak UK Sterling will of course make import costs higher, lead to higher general inflation and thence put pressure on household incomes and lead to higher borrowing costs and in the long-term lower trend growth. Sterling dropped around 20% against the Euro and Dollar since the Brexit referendum and indeed this caused higher inflation – the interest rates to go up one 0.25% notch and lower GDP growth rates. All the Brexit uncertainties are causing some pretty serious uncertainties that have kept a lid on house prices – and indeed they have started dropping in London and much of SE England.

US Real Estate: In the next few years – for the USA the shear magnitude of their new oil production, low cost gas supplies and positive impact this is likely to have on the strength of the dollar are likely to have a positive impact on the value of the dollar. Everyone can criticize Trump for his pollical view – however he is a business man and tough negotiator – he’s likely to get deals done that boost US industry with his America First philosophy so US real estate prices are likely to see a positive impact while he is in power, particularly in places like New York and Florida.

Middle East: The property prices that are likely to be worst affected by lower oil prices at $50/bbl and pressure from US oil shales drillers are Middle East and Africa property prices as oil export revenues drop.

For a closer look at predictions on property price in the UK and around the world, we will issue our 2019 predictions by 1 January 2019. 2019 is shaping up to be a very turbulent year with Brexit, Trump, Putin. Middle East dynamics hints of a major economic slowdown coming from China. If you have any comments or queries, please contact us on  

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