Throughout my years on Wall Street and to this day, one question has always bothered me. I have never got a good explanation as to why the price of crude oil and the strength of the USD move in negative correlation. I’ve heard many different arguments but none are foolproof. I’ve even read that there is no causality in the relationship, that’s it’s all in our minds.
The main argument seems to be that as most commodities, including crude, have historically been priced in dollars, if the dollar strengthens, it takes less dollars to buy a barrel of crude, and vice versa, hence the reverse correlation. This seems to make sense, but is it just the dollar that drives the relationship? Can an increase or decrease in the price of oil be the determining factor as well? Many explanations have focused on the economic impact of interest rate changes and the possible associated demand implications they would bring. But what about supply? What if, like today, the supply of oil is plentiful and growing due to geopolitical changes in the production of crude? Will this drive a stronger dollar as well? Or is it the stronger dollar that has pushed the oil price lower?
For supply and demand related solutions to this investment quandary, wouldn’t there be a lag time to a direct causality? For example, if interest rates rise, wouldn’t it take a while for this to hit the demand side of the equation and impact the oil price? Historically the correlation has been much more immediate. Is it the case that the market is just looking forward to these economic consequences?
Another wrench could be thrown into the discussion. Now that many countries are trying to remove the USD as the commodity trading currency and replace it with their own domestic currencies, how will this impact the USD/crude relationship? Will the yuan and/or the euro or ruble begin to act in the same manner in conjunction with commodity prices? This remains to be seen.
As we have seen recently with the severe drop in the price of crude, the dollar has strengthened accordingly, confirming the historic negative correlation we have been discussing. The question in my mind is, with all of the geopolitical changes in the production of crude, will this relationship exist in the future? One can foresee a situation where the United States will not import much oil at all in a decade or so, maybe sooner. Will oil and the dollar still react in the same way then?
Perhaps we should limit the conversation to a very short-term horizon. Oil is at a multi-year low. The dollar is at a multi-year high. Demand for crude is falling due to an economic slowdown outside the United States. The supply of crude is at very high levels with no end in sight as American fracking keeps pumping and OPEC refuses to cut production to shore up the price. What will happen when this dynamic changes. What if 500 rigs come off line like T. Boone Pickens forecasts? What if Saudi Arabia decides to help out its OPEC friends and cut production? What if global economic activity shows signs of life and the price of crude starts to rise?
The high probability is that the historical negative correlation between the price of oil and the strength of the USD will remain in place, regardless of whatever reason you attribute to this causality. That means the USD will weaken. It’s a matter of when, not if. Which will be good news for the Loonie which has been firmly tied to that barrel of oil for the last 6 months.
Loonie and Oil, sinking together
L Todd Wood
L Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is a contributor to Fox Business, Newsmax TV, and others as well as Agility Forex.