Is the US Dollar Driving Oil…or Vice Versa?

05/20/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Oil prices have been on a tear. Since the beginning of the year, the price of what many people call liquid gold has increased more than 30%, from $43 a barrel in January to an intraday high of $60 a barrel in mid-May. Many factors have contributed to the rise in oil prices, including improved growth prospects, speculation, and the weakness of the US dollar. The outlook for the two economic giants— the US and China—has improved materially over the past month, leading many people to believe that the global recession is almost over. This rosy outlook was confirmed by an improvement in US and Chinese economic data and by comments from central bankers around the world. In the beginning of May, Federal Reserve chairman Ben Bernanke told Congress that the recession is easing and that growth should begin by the end of the year. Most other central bankers expect their countries to return to positive growth in 2010. Given that oil prices plummeted in the second half of 2008 because of deleveraging and the fear of deep recession, the promise of a brighter tomorrow is driving oil prices back up.

However, a slower pace of contraction and the prospects for increased demand are not the only reasons why oil prices are higher. The recent weakness of the US dollar is contributing to the recovery. Of course, many people will argue that the dollar is weaker because the US economy is doing better, which is true, but the relationship between the price of oil and the value of the US dollar is too significant to ignore. Since the beginning of 2008, the correlation between the price of oil and the dollar index has been roughly -0.90. This means that 90% of the time, when the dollar index falls, oil prices rise. The following chart shows the tight correlation between the two instruments. The dollar index is inverted to show the correlation more clearly. Although the correlation broke down from the beginning of January 2009 to the end of February, it picked up in March and has remained strong throughout the month of May.

The value of the dollar can impact oil prices, but is it also possible that the rise in oil prices can impact the US dollar? Before exploring this question, let us examine why a move in the US dollar leads to a move in oil.

Why the Dollar Drives Oil

Oil is priced in US dollars. According to OPEC (the Organization of Petroleum Exporting Countries), the relationship between oil prices and the dollar is almost mechanical. When the dollar falls in value, oil prices have to go up in dollar terms to stay constant in euro terms.  Oil producers receive their oil revenues in US dollars and need to be compensated for the fluctuations of the greenback. This does not always hold true, of course, otherwise the correlation would not have broken in the beginning of the year.

Why Oil Drives the Dollar

Yet it can also be argued that rising crude prices are driving the US dollar lower. A study by members of the IMF in 1996 found that a ten percentage-point rise in the real price of oil induces a two percentage-point real depreciation in a typical OECD country’s real exchange rate. This should not be completely surprising, because a higher price of oil does result in higher cost of oil imports for the US, which in turn leads to a higher current account and trade deficit, which is dollar bearish. It also affects growth. When oil prices were nearing $150 a barrel, gasoline prices in the US went as high as $4 per gallon. It served as a tax for consumers and affected the profitability of companies significantly. Remember how airlines had to add fuel surcharges just to stay profitable? These fuel surcharges have since been reversed, but remain fresh in the mind of consumers. Higher oil prices hurt growth, which in turn hurts the outlook for the US economy. Although this is more of a “longer-term” impact, it is one that cannot be forgotten.

To add to the confusion, the monetary policies of central banks, OPEC production levels, and speculation have all contributed to the previous moves in oil prices. Current and future monetary policies impact both exchange rates and commodity prices because, according to a study done by Harvard Professor Jeffrey Frankel in 2006, the rise in the price of oil is equal to the long-run real oil price and the real interest rate adjusted by convenience yield (which is the option of having oil).

Dollar and Oil: Schizophrenic and Symbiotic Relationship

Therefore, the reliable conclusion that we can make is that the relationship between oil prices and the US dollar is both schizophrenic and symbiotic. When oil prices were hitting record highs in July 2008, it can be argued that the price of oil was driving the value of the US dollar because of concerns about the strain it would have on the US economy. However, currently it is more likely that the dollar is driving the price of oil because the outlook for global demand is not clear and investors are less focused on the impact that higher oil prices can have on trade than they are on its signal of stronger growth.

By Kathy Lien, Director of Currency Research at GFTForex.com

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