Yuan Not a Done Deal for Oil

A weaker dollar should make crude oil cheaper for China, but there are myriad complications to the story.
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Oil companies have barely had to lift a finger to reap the reward of surging oil prices lately. For instance,

Exxon Mobil

(XOM) - Get Report

on Thursday reported quarterly earnings that soared 32% from the prior year, even as its production of oil and gas fell 4.3%.

Elsewhere,

Royal Dutch Shell

(RD)

said its second-quarter earnings surged 26% despite disappointing production, while

Marathon Oil

(MRO) - Get Report

said second-quarter earnings jumped 91% from a year ago.

Some expect that China's revaluation of the yuan against the dollar guarantees more of the same upbeat results for energy companies. According to conventional thinking, a stronger yuan means China would have to pay less to purchase oil, which is priced in dollars, and would therefore increase its demand of the commodity it so craves for its exponential growth.

But as usual, the so-called conventional wisdom provides an oversimplified view of the situation. Notably, the price of oil fell slightly after China last week announced a 2.1% revaluation of the yuan, widely expected to be a first step in a very gradual process.

The yuan's revaluation "could potentially be a slight negative factor for oil prices" on balance, according to Lehman Brothers analyst Paul Cheng, who expects oil prices to remain in a range of $45 to $55 per barrel for the balance of the year and dip to $40 to $50 per in 2006.

First, the minuscule size of the yuan revaluation so far isn't likely to have any meaningful impact on Chinese demand one way or another. And "China is already buying all the required oil to sustain its economy at the moment," which means a stronger yuan is unlikely to boost its appetite, according to Chen.

Second, analysts believe that China could gradually revalue the yen by up to 10% over the coming year. If that were to happen, it's the impact on Chinese economic growth -- which has relied mainly on exports made cheaper by the artificially low yuan -- could become a concern for oil prices.

In addition, cheap production costs in China and throughout Asia have helped keep global inflation at low levels. Should those costs rise due to the stronger yuan, global growth also could be crimped -- which also would reduce demand for oil.

Third, the price of oil hasn't been that well correlated with the value of the dollar over the past few years. Again, this contrasts with the conventional thinking that a weakening dollar makes the same amount of oil cheaper on a nondollar currency basis. In theory, those planning ahead will therefore increase the quantity of oil they buy to save money, thereby pushing the price of oil higher. Likewise, when the dollar strengthens, the price of oil should come down.

Using a regression analysis, Chen notes that the presumed correlation worked somewhat between 2002 and 2004. The dollar weakened (it fell 22.6% vs the euro) while oil prices rose 33% during the period. But since the end of 2004, while the dollar strengthened (it rose over 11% vs. the euro), oil prices rose more than 30%.

One, of course, could argue that part of the explanation lies with China's yuan peg to the dollar, which neutralized any strengthening in the greenback. China, which is now the world's second-largest consumer of oil behind the U.S., lifted oil prices just by the sheer size of its needs and the fast pace of its growth.

The effect on oil might therefore boil down to how China handles the yuan's revaluation process, balancing out the risks to its growth, inflation pressures and political pressures from the U.S. and Europe.

"You may have this a balancing off between the different implications of an appreciating yuan having a fairly neutral impact on crude oil prices," says Jason Schenker, economist and energy analyst at Wachovia.

Even before China announced the yuan's revaluation, the economist expected the dollar to weaken in the second half of the year. He also expects crude oil prices to average $53 per barrel for 2005. This implies a downtrend in September, after the end of peak driving season in the U.S., followed by another uptrend ahead of the winter and its boost in demand for heating oil.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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