Oil and the Dollar: The New Relationship

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US energy dominance has altered a fundamental economic relationship. Today, rising oil prices are associated with a strengthening US dollar, whereas rising oil prices once caused the dollar’s exchange rate to decline. Rising US oil, natural gas and food exports, as well as the market disruptions caused by the war in Ukraine, explain the change in this fundamental linkage. The consequences for countries that depend on imports of food and energy, as well as nations that rely primarily on oil and gas exports, could be profound.

It is often said that a picture’s worth a thousand words. The statement is true in the case of the connection between the dollar and oil prices. In the past, rising oil prices were always associated with a decline in the dollar’s exchange rate. The rate decrease cushioned world consumers from rising prices. That relationship is now broken. Today, rising oil prices are associated with an increase in the dollar’s value. Thus, for countries that import oil and natural gas, the impact of a rise in the dollar price of oil and gas is magnified in their currencies. Figure 1 below captures the change in the relationship.

The data shown in the graph compare the US dollar’s “effective exchange rate” with the dated Brent price. The exchange rates have been computed by the Bank for International Settlements (BIS), the world’s central bank, since 1964. The index is adjusted for inflation.

Our research shows that the Brent price was negatively correlated with the BIS dollar index from 1980 to 2020. Our research also shows that the relationship changed over time.

The graph presents the historical relationship between the index and oil prices from the end of the Great Recession to 2016. During that period, a 10% increase in the Brent price would generally lead to a 1.6% decline in the dollar’s exchange rate.

As the figure illustrates, today the relationship has reversed. Since the beginning of 2021, a 10% increase in Brent leads to roughly a 1.5% increase in the exchange rate.

This transformation was first identified by economists at BIS. In their report, the authors explain that the US and the dollar have benefited from the food and energy price shocks caused by Russia’s invasion of Ukraine. They go on to acknowledge that this energy price episode differs from previous ones because the terms of trade for the US have been altered by the country’s transformation into a significant energy exporter.

The changed relationship is captured by data on the US trade balance in energy collected by the US Department of Commence on trade and published in the US Energy Information Administration’s Monthly Energy Review. Figure 2 below presents these data along with the dated Brent price.

From 2005 to 2015, the US merchandise energy trade balance was negatively correlated with the Brent price. The situation changed in 2019 as shale production surged. It will change further as high global natural gas prices combined with the completion of LNG plants in the US further boost US energy exports.

Increased Vulnerability

Comparing the period from 2009 to 2021 and the more recent period, one notes an increased vulnerability of the economies of oil-importing countries. Before a $10 per barrel increase in the Brent price caused a roughly 1.5% decline in the dollar’s exchange rate. Now a $10 increase causes an approximately 2.5% increase in the exchange rate. Taken together, the swing is roughly four percentage points in the exchange rate for every $10 move in oil prices from when the US was a major oil and natural gas importer to today. This is the consequence of our emergence as an energy exporter.

The exchange rate impact will likely increase as more LNG export facilities in the US are completed, assuming global natural gas prices remain high. Thus, the effect of the dollar’s rising value will be felt everywhere.

For example, an increase in the Brent price to $125 per barrel after the G7 impose an oil price cap on Russian oil will likely raise the BIS dollar index by 10%. This increase will complicate global stabilization efforts. Indeed, senior International Monetary Fund (IMF) officials have already been commenting on the strengthening dollar’s impact, particularly on emerging market countries.

Economic Growth Constrained

The changed relationship between oil and the dollar means that the dollar’s rising value, combined with rising oil and gas prices, will constrain economic growth. In the past, a weakening dollar cushioned oil consumers in much of the world from rising energy prices. Today, consumers face a double whammy: higher dollar prices for oil and even higher prices in their own currency. The impact is already visible in Japan, where petroleum prices have increased by 160% from the beginning of 2022 compared to 75% in the US.

In the past, the negative correlation between the dollar and oil prices moderated the impact of rising prices on global oil consumption. The reversal, tied to growing US oil exports, means that the impact of an oil price rise on global consumption will be magnified by a strengthening dollar.

The intervention by IEA countries in the world oil market through the large strategic stock release has muted the most severe potential impacts of rising oil prices and the dollar’s associated strengthening. Our research reveals that the dollar’s exchange rate, as measured by the BIS index, is roughly 7% lower than it would have been had strategic stocks not been released. In other words, the release of strategic stocks has made a much more important contribution to continued global economic stability than previously thought, given the commentary by officials at BIS and the IMF.

An oil price boost associated with the G7’s imposition of an oil price cap could worsen these impacts. The price rise will raise the dollar’s value and create a worsening global economic situation if the BIS and IMF analyses are correct. The price increases and economic impact could, however, be remedied by further strategic stock releases.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Oil Prices, Oil Trade, Macroeconomics
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