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Vol. 23, No. 3 Week of January 21, 2018
Providing coverage of Alaska and northern Canada's oil and gas industry

What is causing what?

As the dollar value goes down the oil price goes up in international markets

Alan Bailey

Petroleum News

It has been recognized for a number of years that there appears to be an inverse relationship between the global price of oil and the value of the U.S. dollar in international currency exchange markets. In other words, as the price of oil goes up, the value of the dollar falls, and vice versa. And an inspection of graphs of the oil price and the dollar value shows one graph to be a near mirror image of the other.

So, does this mean that the current climb in the price of oil will reverse if, for some reason, the current slide in the dollar exchange rate ends?

An explanation?

There is a simple and enticing explanation for the oil price/dollar correlation, given that oil is generally traded in U.S. dollars. If the economic value of oil were to remain constant, a drop in the value of the dollar would result in more dollars being needed to buy a barrel of oil. And so, the dollar price of the oil would increase. Using the same line of reasoning, an increase in the value of the dollar would reduce the dollar cost per barrel of oil.

The problem with this line of argument is that the economic value of oil is not constant, but varies in response to the economic forces of oil supply and demand. And most analysts agree that swings in the oil price reflect the fundamentals of the oil market. The oil price crash in 2014, for example, resulted primarily from an oversupply, as increasing amounts of U.S. shale oil came on line, while the recent upsurge in the price appears to have resulted from buoyant demand coupled with oil production quotas enacted by the Organization of the Petroleum Exporting Countries and Russia.

Similarly, the value of the dollar in international exchange markets is impacted by dollar demand levels resulting from factors such as the scale of the U.S. trade deficit, interest rate levels for dollar denominated bonds, and demand for dollars as a de-facto international reserve currency.

In fact, the conundrum of the linkage between oil and dollar pricing presents a classic example of the problem of interpreting a statistical correlation as a result of cause and effect. A correlation does not prove a cause. And, while the oil/dollar correlation does seem to indicate some underlying relationship, that relationship could result from some factor that impacts both.

A number of perspectives

A number of perspectives on the conundrum have been published over the years.

A paper published by Yi Zhang from Suffolk University, Boston, in 2013 in the International Journal of Energy Economics and Policy presented a statistical analysis that questioned whether the pricing correlation actually exists. That paper also presented an overview of previously published work, finding that a preponderance of authors had concluded that the oil price has been the driving force behind what many see as a valid correlation. Some have argued that an increase in the price of oil has increased the dollar income of oil producing countries, thus enabling these countries to use U.S. dollars to buy goods outside the United States, and hence cause the dollar to depreciate. Conversely, if the dollar-denominated price of oil drops, oil consuming countries will be motivated to buy more oil and hence push the price of oil up.

A couple of theories

An article published in Oil Sands Magazine in October suggested a couple of theories behind the oil price-dollar value connection. The first theory reflects the concept that variation in the dollar exchange rate inversely impacts the demand for oil outside the U.S., and hence inversely impacts the oil price. The second theory posits that, because the United States is such a massive consumer of oil, the price of oil impacts the country’s trade balance, and hence the dollar exchange rate. Interestingly, this article also points out that oil prices are particularly sensitive to the U.S. dollar exchange rate when the dollar is weak.

An article published on the website last March questioned whether the inverse correlation between the oil price and the dollar will continue, as U.S. oil production and oil exports increase - as a country’s economy becomes more linked to oil production, the value of the country’s currency tends to move more in step with the oil price.

The debate on this topic will no doubt continue. Meanwhile, people in Alaska may want to watch out if they see the value of the U.S. greenback start to climb again.

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