The Dollar-Oil PuzzleSonja Marten, DZ Bank, Frankfurt.
This article appeared in the July 2008 issue of Current Economics with permission of the author.
Key Concepts: Rising Oil Prices | US Dollar | Oil Price Shock |
Key Economies: United States | US Dollar |
The relationship between the USD and oil prices has been subject to many academic studies. The results vary, but most analysts seem to agree that there was a positive relationship between changes in the real effective USD exchange rate and oil prices up until 2002. Since 2002, however, a USD depreciation has, over prolonged periods of time, gone hand in hand with rising oil prices. Looking at data since 2002, we find a negative correlation between the USD and the price of oil. So why was the relationship positive until 2002 and negative since? Is it even possible to define a clear relationship between the USD and oil, or do the correlation coefficients overstate the impact of changing oil prices on the USD?
Our approach suggests that a stable and causal relationship between oil price changes and the USD has only existed in interim periods. It may be possible to show statistical evidence of positive or negative correlations over longer periods of time, but these may reflect a general market trend, rather than a direct causality. The impact of a lasting rise in oil prices, as we are seeing it right now, is however likely to be substantial. It is also indirect: as the oil price rises and concerns about the US economic outlook and inflation rise, the USD declines. The path from oil prices to the USD therefore goes through the economy first, a direct relationship between oil and the USD is not necessarily evident.
The causality between the USD and oil is usually assumed to work from the oil price to the USD, in other words, a rising oil price is expected to result in a stronger (or weaker) dollar. But what are the mechanisms behind this? And is there potentially an argument for this causality to work the other way around? We take a look at the potential effects of rising oil prices on the USD (or vice-versa):
The value effect: A falling USD results, ceteris paribus, in a decline in the purchasing power of oil revenues for the oil exporters. This happens quite simply because oil is traded in USD-terms. In order to compensate for this loss of purchasing power, the price of oil must rise. This would suggest that a falling USD triggers an oil price increase, hence the correlation should be negative.
The inflation effect: Looking at the economic consequences of rising oil prices, inflation is what first comes to mind and it is this effect that is currently causing central banks around the world sleepless nights. Oil importers have little or no control over the price of oil, so the price of oil imports rises step-in-step with rising oil prices. Imported inflation is going to be an even bigger problem if the local currency depreciates at the same time as the oil price rises. For countries other than the US, the “felt” oil price increase is then amplified by the currency movement. Rising inflation can be a positive for the currency as long as inflation is perceived to be “good inflation”, i.e. the inflation that comes with accelerating growth. “Bad inflation” that comes from external factors, such as a rise in commodity prices, and is not matched by an acceleration of domestic growth, is currency negative, It forces central banks into hiking rates despite a slowdown in the economy, in a worst-case scenario central banks have to bring about “controlled” recessions in order to battle the inflation-demon.
The growth effect: Growth is therefore the second route via which rising oil prices can be a negative factor for the currency. Growth is affected by oil prices in multiple ways: purchasing power declines, domestic demand contracts, profit margins decline, and if inflation becomes sufficiently persistent to trigger rate hikes in a slowdown phase, the result can be a recession.
Current account balance: The current account is affected via the trade balance. Assuming for now that the currency remains stable, a rise in oil prices will lead to a reduction in the trade surplus, or a widening of the trade deficit. Since demand for oil is not very price sensitive, there is a negative value effect, which is not compensated by a volume effect, A persistent widening of the trade deficit and hence the current account deficit is a negative factor for the currency. Perversely, a currency depreciation will at least initially lead to a further deterioration: the value effect will widen the trade deficit before the volume effect compensates (this is the so-called “J-curve” effect).
Flow effect: So far the effects of rising oil prices have been negative for the economy and hence negative for the currency. There is, however, one positive side-effect: the increase in demand for USDs and USD-assets. Since oil is traded in USD, rising oil prices result in an increased demand for USD. And until the turn of the millennium, oil exporting countries tended to invest most of these proceeds in USD-denominated assets.
The arguments above suggest that sharp rises in the price of oil should generally be USD-negative — unless the flow effect is substantial enough to counteract the economic impact of rising oil prices. In order to assess the likely dynamic between oil and the USD we therefore need to assess which factor is likely to dominate.
We can safely assume that until 10 years ago petrodollars were invested almost exclusively in USD-denominated assets. The US economy was swinging along on a wave of productivity gains (some of which turned out to be wishful thinking), the equity markets were booming, and the USD was on a lasting uptrend. The bursting of the dotcom bubble and the onset of the USD downtrend changed this. Investors, no longer content to rely on the US engine, started to look elsewhere for investment opportunities. EUR and GBP were two currencies to benefit most from this development and the EUR-share in FX reserve holdings rose from 5% to an estimated 25% on average.
Consequently, it is not surprising to see that the investment behaviour of oil exporters also changed. The Abu Dhabi Investment Authority presently holds an estimated 36% share of its investments in EURs, while the Kuwait Investment Authority holds 40% EUR, 40% USD, and 20% in emerging markets currencies. Similar developments can be observed elsewhere. Russia, for example, holds an equal 45% share in USDs and EURs, and the Chilean sovereign wealth funds (SWFs) allocate close to 40% to EURs and a 50% share to USDs.
The investment behaviour of oil/commodity exporters has therefore changed considerably and is no longer as exclusively focused on USD-denominated assets as it once was. As the propensity of oil exporters to invest their oil revenues mainly in USD has declined, so has the positive impact of an oil price increase on the USD.
As mentioned above, the reason for the oil price increase also affects the market reaction. A temporary oil price increase, that perceived as being temporary from the onset, is less likely to have a notable effect on the USD. In particular, it is unlikely to have a notable negative effect on the USD. While the positive influence on the USD from rising oil prices is a function of portfolio flows, which are likely to be adjusted rapidly, the negative effect comes from changing perceptions of the economic outlook — an adjustment here is likely to be slow. In other words, it takes more than a temporary blip in the oil price to lead to a downgrading of growth expectations.
1973 oil crisis: The 1973 crisis began in October 1973 when OPEC announced that it would no longer ship oil to nations that supported Israel in its conflict with Syria and Egypt (Yom Kippur War). Furthermore, OPEC members agreed to use their leverage to increase oil prices. This pushed the oil price from 3 USD per barrel to 12 USD by the beginning of 1974. Central banks of Western Nations decided to cut rates aggressively despite the increase in inflation, trying to stabilize their economies, nevertheless many economies underwent a period of stagflation. At the beginning of the crisis the USD was in a downtrend, which was interrupted briefly throughout the oil crisis, and the USD rose between late 1973 and early 1974. While concerns about the prospects for the US economy undoubtedly rose as a result of rising oil prices, the USD managed to gain on the back of rising demand for USD. Throughout the initial stages of the 1973/74 oil crisis the correlation between oil and the USD was strongly positive.
The 1979/80 oil crisis: This crisis occurred on the back of the Iranian Revolution, during which the Shah of Iran fled the country and Ayatollah Khomeini seized control of the government. The revolution had a massive impact on the Iranian oil sector, and even once oil exports resumed, they remained at low volumes. In 1980 matters got worse when Iraq invaded Iran and the oil production in both countries was severely disrupted. The oil price rose from 15 dollars per barrel in early 1978 to levels around 35 dollars in early 1980. The correlation between the USD and oil was only moderately positive during this period.
The 1990 oil crisis: This crisis was considerably briefer and less pronounced than the previous two crises. It lasted a mere 6 months and was the result of the Gulf War. Oil prices rose from 15 USD per barrel to 40 USDs, but declined rapidly thereafter. Throughout this period the USD declined and the correlation between USD and oil was moderately negative.
Oil prices since 2007: Since 2007 the oil price has once more risen sharply. The causes for this increase are a topic of much debate, at this point suffice it to say that it is likely to be a combination of a) increased demand, b) the discovery of commodities as investment assets, and c) speculation. Throughout this period, the correlation between USD and oil has been strongly negative — as the oil price rose, the USD continued on its downward trajectory. Unlike in the early 1970s, there was no offsetting increase in demand for USD, instead the diversification of oil revenues into other currencies added to USD downside.
Lessons From History
Considering the crises listed above, we have 4 very different examples for the relationship between USD and oil prices: the 1973/74 crisis went hand-in-hand with a sharp USD appreciation, while the present oil price surge has gone hand-in-hand with an even more pronounced USD depreciation. The effect of the 1978/79 and 1990 situations on the USD was less significant. So which factors determine the likely impact a surge in oil prices is likely to have?
In our view it’s a combination of three factors: a) what is the current economic environment, b) is the oil price increase viewed as potentially lasting, and c) what are the portfolio preferences of oil exporters? In a situation where economic growth is weak and investors and consumers conclude that the oil price increase will potentially be a lasting phenomenon, then this is likely to be USD negative unless the positive impact from the investment of petrodollars outweighs. An external shock, which may have only a limited impact, on the other hand, may have little or no direct impact on the oil price.
There are three main scenarios:
Temporary oil price shock: This is the most benign scenario, where investors almost immediately realize that the oil price increase is going to be temporary, confidence returns rapidly, and lasting effects on the currency are unlikely. In this case the correlation between USD and oil may be positive or negative, but there is unlikely to be a strong causality either way.
Lasting rise in oil, robust fundamentals: In this scenario the oil price rises and is perceived to remain high for a long period of time. Sound economic fundamentals allow the central bank to react to rising inflation by hiking rates. This has some negative impact on growth, but not enough to trigger recession fears, so the pricing in of rate hikes is likely to be USD positive. Further support for the USD should come from rising demand for USD and USD-denominated assets.
Lasting rise in oil, weak fundamentals: This is the scenario we faced in the early 1970s and it is the scenario we are facing at the moment. The oil price increase negatively affects demand and growth, while pushing inflation higher. Rate cuts are often impossible, as are rate hikes. At present this combination of factors is adding to negative USD-sentiment and contrary to the early 1970s. As petrodollars are increasingly invested outside the US, the USD comes under additional pressure.
The World Outside the US
So far we have mainly talked about the US and the USD, but a rise in oil prices has an impact not only there, it’s a global concern. Not only does it have a significant negative impact on the growth prospects of oil importers, it also results in a substantial wealth transfer from oil importing countries to oil exporting countries. Given that these may have different investment preferences (global allocation), this shift is also relevant for the forex market.
The first question we need to address is which countries are most dependent on oil imports, and which countries face the greatest cost of rising oil prices (i.e. which countries have had to deal with a double-whammy of rising oil prices, still-high imports, and a falling currency versus the USD). The table below ranks countries according to these measures.
The US clearly had to bear the brunt of the oil price increase: it is the biggest importer of refined products. This, combined with the 10% USD depreciation since the middle of last year, has resulted in a sharp increase in inflation. The Euro zone on the other hand, has been more insulated against the rise in oil prices, given that at the same time as oil prices increased, the EUR has appreciated by more than 15% against the USD. The same counts for the likes of China and Japan. This is not to say that these countries have not suffered negative consequences from the rising oil prices, but the impact was at least partially cushioned by the currency appreciation.
So Does Oil Matter?
It is a common failing of analysts to overstate the impact changes of one variable on another. Many times we feel uncomfortable with a conclusion that there is no clear answer to the questions we pose. In the case of the USD and oil, there has clearly been a tendency to overstate the causal relationship.
As long as oil prices move in “normal” cycles, i.e. as long as the oil price development is not excessive, or as long as oil price rallies are perceived to be temporary, the relationship between oil and the USD is unlikely to be strong. Correlation coefficients may be positive or negative, but a causal relationship is not necessarily evident.
A significant relationship between the USD and oil is only likely to be found in times when oil price rallies are substantial and lasting. This has direct negative consequences for growth and can even lead to recession. This is particularly the case when inflation rises to levels that necessitate rate hikes. Ceteris paribus, these economic consequences are negative for the USD. Whether the correlation between the USD and oil is going to be negative or positive is then a function of the demand for USD.
In the early 1970s investors were faced with rapidly deteriorating US fundamentals and rising inflation. Still, the USD rallied in line with rising oil prices. We attribute this development to rising demand for US assets from oil exporters and to safe haven flows into the US. This time around, portfolio flows have not been sufficient to offset the negative economic development in the US. For one, we have been faced with a scenario where the US economy deteriorated sharply while economies elsewhere looked relatively more robust. Secondly, the portfolio preferences of investors globally (oil exporters included) have changed. There is evidence to suggest that oil exporters no longer invest such a high share of their portfolio in US assets, thus no longer providing a buffer against the deteriorating economic outlook.
This shift has substantially changed the relationship between the USD and oil prices. The USD is now more vulnerable to changes in the oil price than it was, say, in the early 1970s. The USD is therefore being hit on several fronts: the rising oil price negatively affects growth, it pushes inflation up and the US-positive effect of rising dollar demand is being reduced by diversification out of USD-denominated assets by oil exporters. In this context, further rises in the oil prices are likely to continue to weigh on the USD.
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