The Oil Price and the US Dollar

by George Hatjoullis

The conventional wisdom is that the oil price is inversely correlated with the US Dollar. A higher USD is associated with a lower oil price. The view is substantiated statistically by models such as that of Quant Insight. The latter identifies global growth, USD and the VIX as the top three drivers of the oil price. Global growth has a positive association whilst USD and VIX have negative associations. The ‘USD’ in question is, of course, the DXY, an USD index based on a basket of currencies and not simply one exchange rate. The Euro accounts for considerably more than half of the basket weight so it is not unreasonable to expect the EURUSD rate to mirror movements in the DXY. A couple of questions are of interest. First, why does the oil/USD relationship exist? Second, what is the main direction of causality?

The oil price is a special case of a wider phenomenon of globally traded commodity prices that are quoted and traded in a single national currency (USD). From the point of view of the producer nation one can see a link. An exogenous price decline for a specific commodity will reduce USD revenue to the producing nation. The local currency should be weakened vis-a-vis the USD by current account pressure. The local currency weakness (USD strength) will enable the local producer to maintain local currency revenue. The eurozone however is not a commodity producer. It is a commodity consumer.

From the point of view the consuming nation, an exogenous decline in the price of a commodity means it requires less USD to import the same amount of the commodity. The lower commodity price may inspire a greater consumption of the commodity but there is no reason to assume that it would be so much greater as to increase the demand for USD from the importing nation above that which it needed before. It depends upon income and price elasticities. It is by no means obvious that an exogenous decline in the price of a commodity will induce the currency of the importer to weaken against the reference currency (USD). The observed relationship is thus slightly puzzling given the eurozone is a huge importer of oil and a major part of the DXY index. Indeed the eurozone and Japan (another importer) account for over 70% of the DXY.

What if there is an exogenous rise in the USD? Producers now have a bonus in terms of local currency revenue and can afford to cut the USD price if need be. Consumers however must now pay more in local currency for the same amount of oil and may thus buy less oil. This would depress the oil price. The direction of causality would seem to be from USD to oil prices. Other things being equal an exogenous rise in the USD will depress oil prices but an exogenous fall in the oil price may not necessarily strengthen the USD. One can thus conclude that the recent weakness in the oil price has been caused in part by independent USD strength. The same is most likely true of all commodity prices.