The Dollar Is Hot, But Not For Long! (Here’s Why…)

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I live in Canada about 50 minutes from the U.S. border. Over the years, I’ve enjoyed many a family trip south of the border for shopping, sightseeing and just a nice change of pace.

However, we won’t be slipping over the border for some U.S rest and relaxation this year.

It isn’t that the kids, the wife and I don’t want to. It has just become a much more expensive proposition.

With the Canadian dollar currently worth less than 78 cents on the U.S. dollar, the incentive to do our shopping, amusement park visits and other recreation in Canadian dollars is very strong.

That really isn’t a big deal for my family. It is a much bigger concern for many Canadian retirees.

For my parents and their friends on fixed incomes who like to winter in Florida, Texas or Arizona, the U.S. dollar strengthening is a real issue. Many winter plans are being changed for this year, with fingers crossed the dollar reverses course quickly.

Will their wishes for a weaker dollar sooner rather than later come true? Is the strong dollar set to weaken?

In order to answer these questions, we need to understand what REALLY created the surge in the dollar in the first place…

A Shrinking Trade Deficit Is Good for the Dollar

A few weeks ago, I came across an article from Princeton Energy Advisors (PEA) that makes an interesting observation on what the principal cause of the U.S. dollar strength over the past year has been. PEA points the finger directly at the huge growth in U.S shale production.

Back in the 1990s, despite being a huge importer of foreign oil, the U.S spent less than 1% of gross domestic product (GDP) importing oil. Remember, back then, oil was dirt-cheap. Today, we find $45 WTI prices astoundingly low. Back then, people assumed society would fall apart if oil hit that level.

When the bottom dropped out of the price of oil in 1998 because of the Asian flu, total dollars spent on oil imports were only 0.5% of GDP.

After 2000, the global oil markets started to get much tighter on the back of surging emerging-market demand for crude. Oil soared to prices previously thought impossible, and dollars spent on U.S. oil imports went from 0.5% of GDP to 2.7% of GDP in 2007. That is a huge change in dollar terms.

Since 2007, U.S. oil production has taken off and the volume of oil imported has dropped each and every year. Oil imports in recent years have been reduced by almost a million barrels per day, year on year.

Over the past 15 months, not only has the volume of oil imported dropped, but so too has the price paid per barrel, further reducing the number of dollars being sent abroad to purchase oil.

After hitting 2.5% of GDP prior to the financial crisis, the amount being spent on importing oil will hit (according to PEA) 0.6% of GDP in the current year. The red line in the chart below shows the amount spent on oil imports as a percentage of GDP. Notice we’re back to levels not seen since 1998.

The amount spent on oil imports has dropped from $400 billion in 2008 to roughly $90 billion this year. That is a $310 billion reduction and a similar improvement for the U.S. trade deficit.

A shrinking trade deficit is certainly a big positive force for the dollar.

Does It Work in Reverse as Well?

If Princeton Energy Advisors are really onto something here and the reduction in spending on oil imports is the primary factor in the dollar’s surge, then I would suggest it is highly likely that a reversal of dollar strength may be in the near future.

The amount spent on oil imports is dictated by two things: the price of oil and the volume of oil imported.

I have no doubt that the amount of oil that the U.S. needs to import is already increasing. As I have been suggesting since December of last year, shale production will be falling in 2015.

I’ve been suggesting for quite some time that the rollover of production started in the second quarter of the year.

Now a lot of people are starting to agree with us, including the EIA, which has recently revised its production reporting methodology. Here is the EIA weekly U.S. production data for 2015, which now show a pretty steep rate of decline:

The EIA data show that production is down to 9.1 million barrels per day, from a peak of 9.6 million barrels per day in June. That is a drop of 500,000 barrels per day in just a few months. The idea that U.S. production would decline at all in 2015 was accepted by virtually no market participants a few months ago. Now I see a growing acceptance of the fact that it is likely declining at a rate of 100,000 barrels per month. Why that hasn’t helped the price of oil… I’m not sure.

Every barrel that U.S. production drops means another barrel of imports is required. The need for imports is also increasing thanks to incredibly strong U.S. oil demand so far this year.

Since Jan. 1, 2015, daily U.S. oil consumption has totaled 19.7 million barrels per day. Over the same eight-plus months a year ago, U.S. oil consumption was only 19.0 million barrels per day.

That is a 700,000 barrel increase in the amount of oil that the United States requires daily.

Rapidly declining production and surging demand mean that the amount of imported oil required is moving in the other direction. What, then, for the other variable, the price of oil? Clearly, both of these factors play a big part in that, but the oil price is set by global fundamentals.

That said, the price of oil must go higher. The current price does not work for any oil producer in the world today, including the OPEC nations that need higher prices to balance their national budgets. Outside of OPEC, supply is dropping virtually everywhere, and even the International Energy Agency now sees 2015 global oil demand up 1.7 million barrels per day (they previously expected less than a million).

I also believe that the oil market is much, much tighter than the most people believe. That is going to be revealed by changes in oil inventory levels that continue to move in a manner that reflects a much smaller-than-anticipated oversupply.

If Princeton Energy Advisors is correct, all of this should also mean a reversal of course for the dollar.

And a happier winter for some retired Canadians.

Keep looking through the windshield,

Jody Chudley

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