The Oil-US Dollar Relationship

It’s no secret that the increase in oil prices over the past three years in particular has been accompanied by a steep decline in the value of the US dollar. Because global crude oil is denominated in US dollars, the impact of higher oil prices on both producers and consumers has been disproportionate in different regions. Market focus on the oil-dollar relationship comes and goes – and with it so does the negative correlation between the two markets. While highly inconsistent historically, the oil-dollar correlation is back in recent weeks, attracting media attention.

Key considerations

• Consumer burden: In theory, the weakening dollar protects non-USD consumers from rising oil prices and hurts US consumers most. In reality, demand in emerging market countries is always price sensitive; in the US, economic growth has greater influence over oil demand growth than price. Many emerging market countries still protect consumers with subsidies, but price caps are getting more and more painful for governments to sustain.

• OPEC’s objectives: While there is likely some truth to the idea that deteriorating terms of trade with Europe and Asia has led OPEC to target a higher USD-denominated oil price, OPEC has increased physical output – not decreased it – as the crude price has continued to rise and the dollar has continued to fall.

There does appear to be an ever-increasing schism in the cartel’s approach to market management though. Pricing oil in non-dollar currencies has long been threatened and even invoked by certain producer countries, mainly as a political statement. However, we continue to believe that a more widespread shift on pricing is both impractical and unlikely in the near term.

• Inflated production cost: For OPEC and non-OPEC producers alike, the weak dollar earned for oil sales also means higher relative local costs of production. The weak dollar does essentially raise the marginal production cost bar.

• Investor flows: More and more investor money has flowed in to commodities as the dollar has continued to weaken. These flows have reinforced the on again-off again negative correlation between oil and the dollar and trading the two markets together is back in vogue.

Too much of a good thing or not quite enough?

Conventional wisdom is that OPEC has become comfortable with and even targets a higher crude price these days in part because dollar weakness has reduced the group’s purchasing power in other parts of the world.  While there is likely some truth to the purchasing power argument, OPEC has increase physical output – not decrease it – as the crude price has continued to rise and the dollar has continued to fall. At its last meeting on December 11, OPEC said it will skip a regularly scheduled first-quarter meeting, a sign that it's ready to let prices climb. OPEC’s revenues have risen fairly steadily in the past several years on higher prices and generally high production volumes. 

There does appear to be an ever-increasing schism in the cartel’s approach to market management though. While Saudi Arabia, OPEC’s biggest producer, led the charge towards increased production in December, OPEC’s hawks increasingly point to the weak dollar as a cross to bear.

Pricing oil in non-dollar currencies has long been threatened and even invoked by certain producer countries, mainly as a political statement. Iran for instance, has arranged for 85% of its oil income to be paid in non-dollar currencies.

Ironically, Venezuela, which imports a larger percentage of its goods from the US than does any other OPEC member and is thus least susceptible to deteriorating terms of trade, has been one of OPEC’s most vocal proponents of moving away from dollar pricing. Venezuelan Oil Minister Rafael Ramirez was previously quoted as saying that the development of a currency basket for pricing oil would be a likely topic of discussion at the next OPEC meeting. However, a more widespread shift on pricing is both impractical and unlikely in the near term.

For OPEC and non-OPEC producers alike, the weak dollar earned for oil sales also means higher relative costs of production.  While disciplined hedging can assuage foreign exchange exposure – and current oil prices do certainly cover even the costs of the highest price barrel of, say, Canadian non-conventional oil – the weak dollar does essentially raise the marginal cost bar. A number of Canadian producers have cited in earnings announcements how the strong Canadian dollar partially offset what has been otherwise stellar returns on increased production and high oil prices.

Oil-USD move together…for now

Perhaps the most oil price-supportive implication of the weak dollar has been the investor flows into commodities. Increased investment in commodities as an asset class is not a brand new phenomenon but an ever-growing one in a climate of low interest rates, a weak dollar, and a frantic search for yield. 

Burgeoning sovereign investment funds have, in many cases, both benefited from high commodity prices and helped bolster them by allocating money to commodity-linked indices and structured products. While macro data on sovereign money is elusive, anecdotally, we see meaningful flows into commodities from the Mideast, Europe and Asia.

Trading oil versus the US dollar goes in and out of vogue and the negative correlation between the two is in fact inconsistent at best. However, on average the negative correlation between the two markets has increased over the last several years.