Don’t Overlook the Dollar Factor for Oil Prices

By Mar 25, 2013, 10:26 AM Author's Blog  

It’s no secret that oil prices and the US dollar exchange rate have an economically robust relationship. The global market for crude oil, after all, is generally priced in greenbacks. It would certainly be surprising if there was no link between the world’s most important commodity and the planet’s reserve currency. But if this connection is conspicuous and inevitable, it’s not always fully appreciated, according to a new study that aims to remind readers of the historical record. “An appreciation (depreciation) of the dollar exchange rate is typically accompanied by a decline (rise) in both global oil prices and oil production, indicating a fall (rise) in global oil demand,” write two economists from Ghent University in “The U.S. Dollar Exchange Rate and the Demand for Oil.”

The paper advises that the oil price/US dollar exchange relationship has been “ignored” in empirical research. Instead, there’s a “growing consensus that global crude oil price fluctuations are mainly driven by changes in the demand for oil—Jim Hamilton’s “Causes and Consequences of the Oil Shock of 2007-08“, for instance. The new study points out that there’s more to the story:

In particular, since global oil prices are predominantly expressed in US dollars, a shift in the dollar exchange rate should affect the demand for crude oil in countries that do not use the US dollar for local transactions. When the US dollar exchange rate depreciates, oil becomes for instance less expensive for consumers in non-US dollar regions, boosting their demand for oil (Austvik 1987).

Here’s how the relationship stacks up through the decades. The chart below compares dollar-based year-over-year changes in monthly oil prices (red line) with annual changes in the dollar’s trade weighted index for major currencies (blue line). History suggests that there’s a tendency for oil prices to rise when the dollar’s weak, and vice versa.

Dont Overlook the Dollar Factor for Oil Prices

(click to enlarge)

It’s hardly a perfect relationship, but it’s too strong to ignore. By that standard, the recent strength in the dollar implies that oil prices aren’t likely to rise from current levels. When the dollar trends lower again, as it one day will, the outlook for oil will turn bullish, or at least the odds for thinking so will rise, according to one paper’s read on history.

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