Is the US dollar driving oil prices or vice versa?

In case you haven’t noticed, oil prices have been on a tear. Since the beginning of the year, the price of “liquid gold” has increased by more than 30% from US$43 (RM150) a barrel in January to an intraday high of US$60+ in mid-May. Many factors are driving oil prices higher, including improved growth prospects, speculation and the weakness of the US dollar. In addition, the outlook for economic giants the US and China has improved materially over the past month, leading many people to believe that the worst of the global recession is almost over. US and Chinese economic data, along with comments from central bankers confirm this rosy outlook. Early this month, US Federal Reserve chairman Ben Bernanke told the US Congress that the recession is easing and that growth should take place by year-end. 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 a deep recession, the promise of a brighter tomorrow is driving oil prices higher.

However, a slower pace of contraction and the prospect of increased demand are not the only reasons oil prices are higher.

Recent US dollar weakness is contributing to the recovery. Of course, many people will argue that the US dollar is weaker because the US economy is doing better, which is true, but the relationship between oil prices and the US dollar’s value is too significant to ignore. Since the beginning of 2008, the correlation between oil prices and the US-dollar index has been roughly -0.90. In other words, 90% of the time, when the US-dollar index falls, oil prices rise. The chart shows the tight correlation between the two instruments. The index is inverted to show the correlation more clearly. Although the correlation broke down from the beginning of January 2009 to end February, it picked up again in March and has remained strong throughout this month.

Is it also possible that the rise in oil prices is driving the US dollar lower and not vice versa? Before exploring this question, we should talk about why a move in the US dollar leads to a move in oil.

Why the US dollar drives oil Oil is priced in US dollars. According to the Organisation of the Petroleum Exporting Countries (Opec), the relationship between oil prices and the US dollar is almost mechanical. When the US dollar falls in value, oil prices have to go up in US 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 been broken in the beginning of the year.
Why oil drives the US dollarYet, we can also argue that rising crude prices are driving the US dollar lower. A study by the International Monetary Fund in 1996 found that a 10% rise in the real price of oil induces a 2% real depreciation in a typical Organisation for Economic Cooperation and Development country’s real exchange rate.

This should not be completely surprising because higher oil prices do result in higher cost of oil imports for the US, leading to a higher current account and trade deficit, which is US-dollar bearish. It also affects growth. When oil prices were nearing US$150 a barrel, gasoline prices in the US went as high as US$4 a gallon or more. It served as a tax on consumers and significantly affected companies.

Remember how airlines had to add fuel surcharges just to stay profitable? These fuel surcharges have since been reversed, but remain fresh in the minds of consumers. Higher oil prices hurt growth, which hurts the outlook of the US economy. Although this is more of a “longer-term” impact, it is one that is worth considering.

Adding to the confusion, central banks’ monetary policies, Opec production levels and speculation 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 Professor Jeffrey Frankel of Harvard University in 2006, the rise in oil prices 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). The relationship between oil prices and the US dollar is both schizophrenic and symbiotic. When oil prices were hitting record highs in July 2008, there is evidence that the price of oil is driving the value of the US dollar because of concerns over the strain it would have on the US economy.

Currently, though, the US dollar appears to be driving the price of oil. 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 its signal of stronger growth.