Relationship between Oil Pricing and the US Dollar IntroductionIn recent years, the price of oil has risen steadily much to the chagrin of consumers worldwide. Coincidentally, the American currency (dollar) has seen a steady depreciation trend during the same period. For example, between 2007 and 2008, the price of oil rose from $65 to $120 a barrel; during the same period, the dollar depreciated by 12% and 15% to the euro and the yen respectively (Feldstein, 2008). While the rise of oil prices and the depreciation of the dollar could be seen as a coincidence, most analysts believe it is not.
The relationship between the dollar and oil is however clear-cut. For example, while Feldstein (2008) argues that the oil prices would remain the same regardless of the currency used to trade the resource, other analysts such as Ramady (2010) argue that the impact that oil has on the dollar is undeniable. The price of oil and the dollarSome observers argue that there is a “direct cause and effect relationship” between the dollar’s international exchange value and oil prices (Jackson, 2010, p.
2). Such an argument is founded on the fact that oil is priced in dollars and hence any depreciation in the dollar’s value erodes oil producers’ purchasing powers. This argument is supported by the International Monetary Fund (IMF, 2008), which notes that a change in the dollar’s value has an effect on commodity prices. The oil-dollar link explained above is not always accepted in all quarters. Grise (2010) for example argues that any changes in the values of the dollar affects the demand of the oil by either causing consuming countries to purchase more (i. e.
when the dollar depreciates), or less (i. e. when the dollar appreciates). Faced with an increase in demand, the oil producing and exporting companies often adjust the oil prices upwards and vice versa (Grise, 2010). Actions by the Organisation of Petroleum Exporting Countries (OPEC) are also cited as having an effect on the oil-dollar link (see figure 1). Writing for the Congressional Research Service, Jackson (2010, p. 3), observes that OPEC’s main objective is to secure “a fair and stable price for the oil the member countries produce”.
Faced with reduced purchasing power, OPEC, which commands more than 40% of the global crude oil output capacity, could deliberately drive up the prices of oil by reducing production. According to Jackson (2010), OPEC could also hold down any increases in oil production in order to stabilise or raise oil prices (see figure 1 below for OPEC’s interventions between 2001 and 2005). Such an action corresponds with the standard economic theory, which states that a reduction in supply of a specific commodity relative to a particular demand level will result in higher prices for the commodity since the demand will outweigh supply.
Additionally, if OPEC’s actions have any impact on the oil-dollar relationship, it must be because market observers, participants and speculators have become accustomed to acting on the stylised notion that a link exists between the value of the dollar and the price of oil. Figure 1: OPEC’s interventions (highlighted in colour)