The global financial crisis has spilled over into the crude oil market, and as a result, diesel fuel prices now are being influenced by financial factors like never before. Prior to the global financial crisis, crude oil prices were largely determined by supply and demand factors. Since the crisis began, however, financial factors have been having a large influence on crude prices. Crude oil has become a financial instrument for investors just like stocks, bonds and currencies.
Many financial institutions are using crude oil as a hedge against the exchange rate of the U.S. dollar. There is a negative correlation between the dollar exchange rate and crude oil prices (see chart below). Appreciation of the U.S. dollar exchange rate results in lower crude oil prices, while a depreciation of the dollar results in higher prices.
Oil-producing nations and OPEC want crude oil prices to increase when the dollar's exchange rate depreciates because crude oil is priced in dollars, so any depreciation reduces the purchasing power of oil producers. In order to make up for a decrease in purchasing power, the price of crude oil increases. How long this relationship between the exchange rate of the U.S. dollar and crude oil prices lasts is uncertain.
THE SHOCK EFFECT
What is certain is that the global financial system remains weak. Future shocks to the financial system may have large repercussions on the exchange rate of the U.S. dollar in 2011, implying large changes in crude oil prices which could impact diesel fuel prices. There are many financial risks on the horizon and surely unforeseen events, and governments continue to deal with the aftereffects of the financial crisis.
The sovereign debt crisis in Europe is not over either, as Portugal, Spain and Italy have debt problems that may require a bailout by the European Union similar to that granted to Greece and Ireland. Does Europe have the political will to bail out these other countries, or will these countries default on their loans, leading to a potential disintegration of the euro?
In the U.S., the federal budget deficit is unsustainable at current levels. Will the federal government demonstrate a plan that shows a commitment to lowering the budget deficit over time? If not, will investors lose confidence and stop investing in U.S. assets such as Treasury securities, just as investors lost confidence and stopped investing in Greece's securities.
The Federal Reserve Board's quantitative easing II is a risky approach; increasing the supply of dollars puts downward pressure on the U.S. dollar exchange rate while increasing the risk of inflation. These are just some of the risks to the global financial system that may result in large changes in crude oil prices in 2011.
In short, the global financial system is weak, so a moderate shock is capable of exacting large repercussions resulting in large changes in the exchange rates and the price of crude oil that will ultimately change diesel fuel prices. How long financial factors influence crude prices is uncertain, but in the near term, financial factors will play a large role in influencing crude prices. Investors are uncertain about the value of world currencies and paper money has no value if people lose faith in the purchasing power of the currency, so investors are buying commodities such as crude oil and gold as a hedge.
Since crude oil inventories are at high levels, a spike in diesel fuel prices is not likely to be the result of a shortage such as that which occurred in the 1970s. However, it will more likely be the result of large changes in the currency exchange rates due to shocks within the global financial system. Large changes in the financial system could also result in large decreases in crude oil prices. In conclusion, there are large upside and downside risks to diesel fuel prices in 2011 since the global financial system is fragile, and financial factors are currently playing a large role in determining crude oil prices.
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