Dollar Driving Oil Prices, Or The Other Way Around?

Posted by Bull Bear Trader | 5/02/2008 07:23:00 PM | , , | 0 comments »

A lot has been written about the cause and effect between the falling dollar and the rising price of crude oil. It is usually assumed that the falling dollar is resulting in the price of crude oil being higher than it should be. This is the position that OPEC has recently stated. As reported in the Economist, Harvard economist Jeff Frankel argues that low real interest rates lead to higher commodity prices such that when real rates fall, commodity producers have more incentive to keep their asset rather than sell. This also gives speculators an incentive to sector shift into commodities.

The correlation between the euro/dollar exchange rate and the price of oil has risen over the last few years, increasing from 1% between 1999 and 2004 to 52% in the past six months. Others argue that the link is also influenced by accounting since if the dollar falls, the dollar priced commodity must rise for its overall price to remain consistent and stable. But commodity prices have increased against other commodities as well.

But is the correlation the other way around? Analysts at Goldman Sachs feel the correlation is in the opposite direction. High crude oil prices drive the dollar down since oil exporters import more from Europe than America, with less of their revenues in dollars. Another possible reason for the correlation is that many emerging economies peg their currency to the dollar, and therefore also have a loose monetary policy. These loose dollars increase domestic demand, thereby putting pressure on all commodities, especially crude oil.

In the end, both effects are related to the dollar and may be having the same result, whether rates are low - thereby driving up dollar dominated prices, or whether lower interest rates are promoting a looser policy - thereby increasing demand.