Oil And The U.S. Dollar: What's Wagging What?

| About: The United (USO)
This article is now exclusive for PRO subscribers.


The oil and US dollar negative correlation is a recent phenomenon.

Increasing financialization of oil has strengthened its price relationship to other financial assets.

Long-term fundamentals will drive oil prices.

One of the ongoing mysteries in the investment community and among academics has been the recent negative correlation between the strength/weakness of the US Dollar and oil prices. This topic is akin to determining if the dog wags the tail or the tail wags the dog, and like that conundrum, there's still much uncertainty. In this article, we'll try and walk through a few academic studies and then posit our view. By no means is it exhaustive, but let's give it a try.

Some investors have said that oil prices will increase or decrease based simply on whether the US Dollar will strengthen or weaken, and for the past 15 years, the US Dollar has been, if not married, at least in a relationship with the price of oil. Here's a chart:

Like some relationship, you can plainly see that the two are highly negatively correlated, so when one is high the other is low and vice versa. The financial press has explained this by saying that oil is an international commodity bought and sold in US Dollars. So when the US Dollar strengthens, oil becomes more expensive for countries that have to exchange their own local currencies into US Dollars to pay for it. More expensive oil means these countries use less oil, reducing oil demand and oil prices. Reverse this whole equation and the opposite is considered true (i.e., weaker Dollar means cheaper oil, spurring higher demand and a higher price).

This correlation was again reinforced with Brexit. On June 24, the first day after the Brexit vote, investors sold foreign assets in a panic, exchanged their local currency to US Dollars (i.e., buying US Dollars) and invested the money in US Treasuries. The rush of investor demand immediately strengthened the US Dollar and oil prices (again denominated in US Dollars) fell. The media then explained that once again a strengthening US Dollar affects oil, and oil demand, which is why oil prices fall.

We think this explanation likely oversimplifies it. In taking a look at recent academic papers to gain some additional perspective, it's become fairly clear that a few factors other than supply and demand are now driving oil prices. While Christian Grisse at the Federal Reserve Bank in New York wrote "there is little empirical evidence that the global demand for oil is in fact responsive to changes in the Dollar", he concluded that it does have an effect on price. (See C. Grisse, What Drives the Oil-Dollar Correlation? (Federal Reserve Bank of NY (December 2010)). The difficulty has been determining what affect it has because the correlation between the strength of the US Dollar and oil prices is a recent one (i.e., having existed for only the past 15 years (since 2000)), and whether its causation or mere correlation.

In an ECB Working Paper (1689 (July 2014)), the authors found that there was in fact strong correlation in the daily fluctuations of oil prices to other financial assets trading in the market. There is also a strong link between volatility in the financial markets and its impact on oil prices (i.e., risk shocks and equity market shocks typically result in a flight to safety, a buying of US Dollars/Treasuries and a decline in oil prices).

The authors postulate that the recent correlation between oil and the US Dollar stems from the financial crisis in 2000 and the subsequent central bank interventions; one that was reinforced again in 2008. Oil's affect on (or by) other financial assets may also be linked to the rising financialization of oil as investors today use the commodity as a proxy to trade their ideas (e.g., oil ETFs, indexes, derivative instruments, etc.). The increasing sophistication of derivatives has also affected the trading of oil and made it subject to factors beyond fundamentals (e.g., stock or bond market). This means that in the short term, prices are increasingly governed by something other than supply/demand, and oil prices can be battered or lifted by market sentiments.

We think though that over the long term, fundamentals will drive oil prices, as the basic supply and demand factors still anchor oil because it's a physical commodity. While important, today's headline factors have largely short-term impacts. Here's a simplified illustration of how we see external factors beyond fundamentals affecting oil prices.

If oil is becoming increasingly financialized as a commodity, then that also means that like most financial assets, they are a reflection/representation of something fundamental, something underpins the instrument. As such, most of the day-to-day volatility becomes noise over the long term, and fundamentals matter. We believe that in oil's case, most of the noise is tempered and buffered by oil inventory, which today is at an all-time high. Accordingly, the back of the strip moves (and sometimes even the front of the strip) much less than what the media breathlessly suggests. True supply/demand imbalances that are surprising will continue to "jump the gap" and spike short- and long-term prices (in particular, demand shocks as supply is easier to measure and forecast than actual demand), but for the large part supply/demand will determine the long-term price. If, however, your time horizon is shorter, then certainly understanding oil's negative correlation to the US Dollar and its direct and indirect causal connection to other financial assets may be more relevant. So while the tail sure moves around a lot, it helps to remember that at the end of the day it's the dog that drags it around.

