The long-term relationship between the US dollar and oil prices

Bloomberg published an interesting article yesterday stating that the USD is expected to appreciate in the future given the US shale oil production boom that could make the US a net oil exporter by 2020. While higher US production will have an impact on global oil markets, how could a strong USD also impact? http://www.bloomberg.com/news/2012-12-17/fracking-boom-is-dollar-boon-in-energy-independence-currencies.html

Firstly let’s look at the current relationship between oil and the USD. At the moment the US is a net oil importer, this means that there is a USD outflow to oil producers such as the OPEC nations. These countries seek to invest this income in a portfolio of assets which are not all priced in USD and hence to make these investments USD must be exchanged for other currencies. This means that as more oil is imported, more USD flows on to currency markets and the USD will depreciate due to laws of supply and demand. With a higher domestic oil output this process should reduce or even reverse, and so the USD is expected to appreciate.

To answer how this stronger USD could impact oil markets, we can look at what the effects of a weaker USD, caused by QE during the crisis, were expected to have on the price of oil. A 2011 article by Reuters  thought that for two main reasons this would case a rise in the oil price. Firstly, oil purchases would become more attractive for holders of other currencies, which results in higher demand for purchases. Secondly, because producers of oil receive USD for their exports, a weaker USD can cause these producers to reduce supply to drive up the oil price such that in terms of their domestic currency their export income remains the same. While OPEC producers have in fact kept supply strong, this has been due to their belief that a higher price could endanger an economic recovery and therefore their future earnings.

So if a weaker USD results in a higher oil price, can we for the same reason expect a stronger USD to result in a lower oil price? Well, in terms of the action producers take, they may be keen to maintain a certain level of income, but it is unlikely they would take action to prevent a higher level of income. The exception to this rule is if they believe a high oil price for non-US countries could again endanger the global economy, however we might hope that this will not be such an issue in 5-10 years if economic growth picks up. Additionally, the changing structure of the global economy and global oil demand may mean that economic growth can support a higher oil price. For instance, if the US becomes a net exporter then the world’s largest economy will benefit from these prices, and providing this money is invested in other economies as well high global growth could persist.

While a stronger USD will make oil purchases less attractive to holders of other currencies, with Eastern economies growing in size and other currencies growing in importance, oil transactions are more and more becoming priced in other currencies. Because of this changing macroeconomic backdrop, other currencies should become less inextricably linked to the USD and the weight of USD in total FX transactions (the USD currently is on one side of xx% of FX transactions) could decrease, with the currency also potentially losing its position of strength as the world’s preferred reserve currency. This may also reduce some of the downside risks to the oil price of a stronger USD.

With a dramatically changing global macroeconomic structure, and the geographies of global oil flows changing, there are therefore plenty of reasons to question whether the current relationship between the USD and the oil price will hold in the future. While these questions may not have such an impact on the short and medium term outlook for oil markets, we should take note of them for the long term direction of where oil is heading.