US Dollar versus Oil

There is commonly an inverse relationship of the US dollar versus oil. On hopeful news the other day that Europe may be on the way to solving its debt crisis, the Euro rose, the dollar fell, and commodities, including oil, rallied. Remember that commodities like crude oil are commonly quoted in US dollars. When the US dollar weakens it does not necessarily mean that there is less demand for crude oil. Thus, as dollar falls, the price of oil often adjusts, upward. Many trading foreign currencies watch oil prices as indications of where the dollar is going and exchange rates of the dollar versus other currencies to anticipate where oil prices are going. Another aspect of the US dollar versus oil prices is that the US economy is the largest in the world. If industrial production is down in the USA the demand for oil falls as well. A weaker US economy commonly leads to both a weaker dollar and lower oil prices.

The producers and users of commodities such as oil and its products of distillation commonly trade options on Forex contracts in order to hedge the currency risk of international transactions. The variation of the US dollar versus oil and versus other currencies can be dramatic over the several months that may elapse between signing of a contract and delivery of crude oil, gasoline, or aviation fuel. Traders may simply trade options on Forex contracts or they may trade options on oil futures. Doing so successfully can make the difference between a satisfactory price for a product and a devastatingly high or low price, depending upon whether one is a producer or customer.

Not all of the US dollar versus oil relationship has to do with the strength of the dollar or demand based upon the health of the US and global economy. Supply is also an issue. In fact it is an issue for both dollars and oil.

First of all oil supply can be precarious. Civil unrest in Nigeria can shut down production, the civil war in Libya certainly did, and the unrest in Egypt and overthrow of long term president Mubarak threatened to close down shipments through the Suez Canal. Today Iran threatens to close the Straits of Hormuz through which an eighth of the world’s oil supply flows. The US Navy patrols the area and sends battle groups through the straits in a show of force. If tensions rise in the region oil prices could skyrocket and not based on a US dollar versus oil formula, simply based upon scarcity.

Interestingly, the supply of US dollars is rising. As part of the Bernanke Doctrine the US Federal Reserve is buying US treasuries in an effort to keep interest rates low. They are doing so with printed money. The world lost trillions of dollars in equity during the 2008 market crash and its aftermath. Housing values are down. Stocks are down. By printing currency both the US and EU are staving off the second dip of the worst recession in three quarters of a century and striving to keep nations like Greece, Italy, Spain, and even France from defaulting on their national debts. The question here regarding the US dollar versus oil is if twice as many dollars floating around will devalue the dollar and make oil spectacularly more expensive.