The Oil-Dollar Seesaw
If you follow business coverage in a typical American newspaper, you might conclude that oil and the value of the U.S. dollar were the two assets that have the greatest impact on the day-to-day lives of most Americans. After all, the strength of the dollar is a quick way to gauge the strength of the U.S. economy relative to the rest of the world and we all feel the impact of oil prices, either at the pump or in prices of everyday products.
And for the last decade, the prices of these two assets have had an interesting—and perhaps surprising—relationship: they tend to move in opposite directions. Generally, when the price of oil rises the dollar falls, and vice versa.
There is no one simple explanation for why these two assets tend to move in opposite directions. But understanding the complex forces that drive these two ubiquitous assets is nonetheless important for investors.
What the Seesaw Looks Like In Practice
From a high point in February 2002, to a low point in March 2008—when Wall Street banks were under tremendous stress—the value of the dollar relative to other major currencies fell by about a third. Meanwhile, U.S. Energy Information Administration data show that the price of West Texas Intermediate (WTI) oil, which is produced in the U.S., rose more than five-fold over the same time period. (The price of Brent crude oil, a more global benchmark for oil prices, more than quadrupled.)
But during the financial crisis, the directions reversed sharply. Between the bailout of Bear Stearns on March 14, 2008, and a turning point of the crisis in March 2009, the dollar’s value increased 18 percent. Meanwhile, WTI prices fell about 60 percent.
Academic studies have been trying to understand this relationship. They show that even short-term market moves in either the dollar or crude oil affect the price of the other asset. For every 10 percent increase in the price of oil, the dollar declines 0.28 percent, European researchers wrote in a 2014 study. When the dollar declines 1 percent, oil prices nudge 0.73 percent higher, they found.
The Conventional Wisdom
Typically, the relationship between oil and the dollar is explained like this: Oil is an international commodity, bought and sold using U.S. dollars. When the value of the dollar rises, oil becomes more expensive for countries that have to exchange their own currencies into dollars to pay for it. People in those countries thus cut back on how much oil they use, and the oil price falls – simple supply and demand.
But some see the relationship differently. “There is little empirical evidence that the global demand for oil is in fact responsive to changes in the dollar,” economist Christian Grisse wrote in a 2010 paper.
Both Grisse and the European researchers laid out a number of other possible explanations. One focuses on oil producers. When the dollar falls, exporting countries earn less money from sales of crude, and may raise prices.
Or perhaps it’s the other way around: oil price moves bump the value of the dollar.
When oil gets more expensive, all goods and services requiring oil – either as a direct input or indirectly as in transportation costs – get more expensive. This puts pressure on the economy, slowing growth and ultimately weakening the dollar.
Along the same vein is another possibility that when foreign exchange investors see oil prices rising, they assume that the economy of the United States, currently a net oil importer and intensive energy user, will take a hit. They then bet on the appreciation of other currencies and the decline of the dollar.
The Complicated Reality
Both Grisse and the European researchers conducted sophisticated analyses of oil prices, exchange rates, and other variables, such as interest rates. Both studies found that sometimes oil markets cause changes in the value of the dollar, and sometimes the dollar nudges the oil price. The correlation goes both ways.
The European paper also pointed out that big swings in other corners of the financial markets, such as the stock or bond market, can affect the prices of both oil and the dollar. In fact, between 11 and 25 percent of the movement in oil prices and the value of the dollar can be chalked up to price shocks that also affect other assets, according to the paper.
When the Chicago Board Options Exchange’s Volatility Index (VIX) rises, for example, oil prices tend to fall and the dollar tends to rise. When the stock market gets rattled, investors will often flee to safe assets, like U.S. Treasury bonds. That tends to increase the value of the dollar, and thus, lower the price of oil, the researchers explain.
But perhaps the most important thing to note is that the inverse relationship between oil and the dollar is a relatively new phenomenon – and it has seemingly grown stronger over time.
Between 1984 and 2001, there was no evidence of a sustained link between the two assets, Grisse wrote. Sometimes, they rose and fell together. Other times, they moved in opposite directions.
The European researchers believe that the strengthening push-pull relationship between oil and the dollar over the last 15 years has been driven in part by the fact that oil has increasingly become a more accessible investment commodity.
They note that an increase in the number of open oil futures contracts (a measure of how many people are trading around the future price of oil) prompts an increase in oil prices. They also note that in the early 2000s, when the inverse relationship between oil and the dollar began strengthening, a variety of exchange-traded funds, index funds, futures and options linked to the price of oil also became more popular among investors.
Though there is no easy explanation for the increase in trading of oil-linked products, one study by researchers at the Oxford Institute for Energy Studies suggests that when investors anticipate either greater demand or tighter supply, trading in oil-linked financial products tends to increase.
In the early 2000s, China’s rapidly growing economy led to a major increase in oil demand, and production did not keep pace. Global oil consumption rose 12.7 percent between 2000 and 2007, while supply rose just 9.6 percent, according to statistics from the Energy Information Administration. With relatively tight supply keeping upward pressure on prices, it’s conceivable that investors simply wanted to cash in on an appreciating financial asset.
There are two important lessons for investors to learn from the relationship between oil and the dollar. The first is that the conventional wisdom floating around the marketplace is often oversimplified, and may not come from hard data. The second is that the commodities we depend on in our daily lives don’t move in isolation. For investors, recognizing that financial assets and physical commodities are tightly interconnected in a complex web is an important consideration that can result in smarter investment decisions.