Photo:Eric Gjerde, Creative Commons, Flickr
It has been interesting to see crude oil climbing to record highs despite the resurgent greenback.
The common belief is that there is a negative correlation between the U.S. dollar and oil, a result of oil being priced in dollars. "As the dollar declines in value, so does the price of oil in non-dollar terms," explains Michael Woolfolk at the Bank of New York Mellon. "Consequently, foreigners bid up the price of oil and other dollar-denominated commodities. The result is that the price of crude oil and other commodities rise in dollar terms as the dollar falls in value against other currencies."
If, on the other hand, the dollar gains in value, so does the price of oil in non-dollar terms. The traditional argument is that a higher non-dollar price of oil reduces the demand from foreigners, sending oil prices lower.
Over the last few sessions we have seen the greenback rebound, but oil prices continue to move higher. Two possible explanations come to mind:
1) The crude market believes that the greenback rebound is unlikely to continue: The key idea is that oil is a storable commodity and hence will be sensitive to expectations regarding future values of the dollar. Because oil markets are more focused on long term expectations, it might ignore short-term currency volatility. This is a plausible idea that merits a separate discussion, but this note will only focus on the second possible explanation.
2) Many developing countries, relying on oil to fuel that growth, have accumulated savings and can now absorb higher non-dollar costs of oil: Over the last few years economists have started referring to the existence of "global payments imbalances", reflected in the growing current account surpluses and deficits among different regions of the world (surpluses mostly, but not only, by a number of Asian countries; deficits mainly by the US), together with a substantial accumulation of international reserves (also by a number of Asian countries). I will argue here that the higher savings rates in developing nations improves their ability to cope with the higher non-dollar value of oil.
Many analysts suggest that long-term forces may play a bigger impact on oil prices than near-term weakness in the world’s biggest economy or a resurgent greenback. The recent Barclays Capital Equity Gilt Study plunges into an analysis of the supply and demand for commodities and the implications for the world in which we live. "Its analysis is not for the faint-hearted," warns Anthony Hilton at the Evening Standard. "Assume, for example, that Chinese and Indian consumption of oil rises over the next 25 years to current U.S. levels, while the rest of the world takes no more oil at all. China and India alone would then consume 160 million barrels a day, against a total current global demand of 85 million barrels."
And here is the point: Scarce commodities will one day go to the highest bidder, and the raw efficiency and high savings ratios of the Asian nations mean that they will be that highest bidders. The higher value of the dollar isn’t going to hurt the developing world’s demand for oil since they have sufficient savings to absorb higher oil prices. In my mind, this will be one of the main reasons why the negative correlation between dollar/oil will break down.
If we assume that the dollar/oil correlation is about to break down, is this a bullish development for the dollar?
"It should go without saying that the strong oil/ weak dollar mix [i.e. the negative dollar/oil correlation] creates real problems for all the Gulf countries that insist (still) on pegging to the dollar," says Brad Setser at RGE Monitor. "They are effectively importing a weak currency and low nominal interest rates when their economies are booming." He adds: "Pegging to the dollar has – at least in my view – been a recipe for macroeconomic instability in many oil exporting economies."
In other words, a negative dollar/oil correlation is a source of macroeconomic instability in oil exporting economies. My argument here is that a positive dollar/oil correlation, or at least a breakdown in the negative correlation, could have a stabilizing impact on the economies of oil exporting countries. If the dollar becomes a stabilizing force for the Gulf economies, it decreases the chance of Gulf countries de-pegging from the dollar. It goes without saying that it would be a bullish development for the greenback if Gulf countries maintain their dollar pegs, and oil continues to be priced in dollars.
Disclaimer: I do not have any currency or commodity positions.