How The Relationship Between Oil Prices and Foreign Exchange Rate Has Changed

Feb 4, 2021 07:35 PM ET
How The Relationship Between Oil Prices and Foreign Exchange Rate Has Changed

A correlation between oil prices, foreign exchange rate, and interest rates has always been there. A spike in oil prices in the early 2000s was mostly attributed to low real interest rates in the U.S and a decline in the real value of the U.S dollar. Likewise, oil prices have always been inversely related to the U.S dollar, which acts as a reserve currency for international transitions.

Crude oil and the dollar moving in opposite directions

The inverse relationship has always existed on a barrel of oil being priced in U.S dollars. Similarly, whenever the U.S dollar strengthens, fewer dollars are required to buy a barrel of oil. Any weakness in the dollar often results in oil being expensive to U.S companies as they have to pay more dollars for a barrel of oil.

US net oil importer status

An inverse relationship between oil and the greenback has always existed in the US, being a net importer of the commodity. Conversely, rising oil prices often trigger a trade balance deficit as the US companies are forced to send more dollars abroad to pay for a barrel of oil.

While the former still holds, it no longer has a massive impact on oil prices, given that the US has risen the ranks to become one of the biggest oil producers thanks to horizontal drilling and fracking technology.

The World's Biggest Oil Producers

The US is now 90% self-sufficient when it comes to energy consumption, thanks to widespread production. As the US oil exports have increased, net imports have declined. In return, high oil prices no longer contribute to a higher trade deficit in the US economy.

US dollar oil inverse relation fading off

Fast forward, things have changed in the US, becoming a net oil exporter. The inverse relationship between the US dollar and oil prices has become more unstable.

As the US role in the global oil industry continues to grow, so is the US dollar increasingly joining other foreign exchange currencies in becoming a petrocurrency. The likes of the Canadian dollar, Russian ruble, and Norwegian kroner rates are highly dependent on oil prices in part because the countries are big oil exporters.

Oil prices implosion

Between 2010 and 2014, oil prices were relatively stable. Hell broke loose towards the end of 2014 as a glut in supply came knocking. Oil prices tanked from record highs above the $100 a barrel level to below the $50 a barrel level, all but rattling some of the oil-dependent economies.

Russian Ruble Tracks Oil Prices

As oil prices more than halved, the Russian Ruble fell in value by more than 50% against the dollar.  Russia’s central bank swung into action by raising interest rates from 10.5% to 17%. The interest rate increase was necessitated in a bid to stem further free fall of the Rubble as oil prices continued to edge lower.

Canada is a net exporter and is also highly impacted by oil price fluctuations. For instance, whenever oil prices are rising, the value of the Canadian dollar tends to increase as the economy earns more US dollars on the sale of crude oil. Likewise, whenever oil prices tank, the Canadian dollar tends to depreciate as the amount of US dollars that the economy gets on the sale of each barrel of oil drops.

Interest Rate Impact on Oil Prices

While interest rates and oil prices have some correlation, they are not tightly correlated, as is the case with other metrics. Conversely, increasing interest rates increases consumer and manufacturer costs. The net effect is a reduction in disposable income that can be used to buy oil.

Fewer people on the road translate to less demand for oil, which causes oil prices to drop. Likewise, whenever interest rates fall, companies can borrow freely and spend money freely, which in return drives oil demand higher.

Interest rates in the US also affect oil prices a great deal, given their net impact on the US dollar strength. Crude oil worldwide is priced in the US dollar on the greenback, being the global reserve currency. Likewise, any monetary policy that affects the dollar strength goes a long way in globally influencing oil prices.

The Federal Reserve is hiking and lowering interest rates in a bid to cushion and stimulate the US economy, which goes a long way in affecting oil prices. For instance, whenever the Federal Reserve hikes interest rates, the same implies that the US economy is solid and growing at an impressive rate.

Dollar Oil Correlation

Likewise, the dollar tends to strengthen against the other major currencies as more people buy the dollar to gain exposure to the US economy. Many times, a strengthened dollar has a net effect of causing a decline in oil prices given the reduced amount of dollars needed to buy a barrel of oil.

The reduced amount of the US dollars needed to buy oil causes American oil companies to spend every dollar in their hands to buy oil and pass the savings to consumers.

Similarly, whenever the Federal Reserve cuts interest rates, the same is interpreted as weakness in the US economy. The net effect is usually a sell-off of the US dollars, which results in further weakening of the greenback. A weakened US dollar often results in a spike in oil prices, given the inverse relationship between oil prices and the dollar.

Amidst a weakened dollar, American companies don't buy as much oil as they would want. This, in return, causes oil prices to be costlier to the US, which consumes 20% of the world's oil.

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