Monday, June 02, 2008

Is the Falling Dollar behind Oil Price Rises?

It's difficult to turn on CNBC, read any newspaper article on oil prices, or listen to other discussions of the topic of oil prices without hearing this theory: really, it's the decline in the dollar that's responsible for the rise in oil prices. "They" advance two reasons for this: first, dollar-denominated oil traded on the NYMEX must go up equal to the amount that the dollar goes down, or it's actually losing value. Second, the belief that the dollar is losing its footing as the world's reserve currency is causing a flight from dollars to commodities and other hedges against a falling dollar. Lots of words, but very little data is usually provided to back this up. I decided to put together a little graph that cuts right to the heart of the matter:

Figure 1: US Dollar Index (Bottom) and NYMEX Crude Oil (Top) contracts concurrent price charts

So, let's look at two periods: before about March 10, 2008, and after about March 10, 2008.

Before March 10, 2008, there was a general (though not very convincing) correlation between dollar movement and oil price movement. We need to remember that correlation does not necessarily equal causation here, even if there are rational explanations for a potential causal mechanism. This correlation extends back into 2007 (not shown--chart begins about Jan. 1st, 2008).

After March 10, 2008, there is not a correlation between dollar movement and oil price movement. The dollar has remained relatively steady and constrained within a relatively narrow trading channel. During this same time period the price of oil experienced one of the most dramatic increases in history.

Problem: How can we infer causation from the rough correlation from 2007 to March 10th, 2008 between dollar decline and oil increase if the two data sets become uncorrelated between March 10th and the present? There are possible answers to this question--possibly because there's a lag time between dollar decline and the move to oil and other commodities, possibly because there was some new countermanding force propping up the dollar since March 10th, or something else entirely. The point isn't that there's no explanation for this--the point is that the break in correlation itself defeats any rational use of correlation as the sole basis for asserting causality. At a minimum, we'd need to perform a three-factor analysis here and see if, then, we can derive a continuing correlation--say between an identifiable fed action data set, the dollar index, and crude oil. To my knowledge, no one in the media who has been bandying about the dollar-oil theory has done that. That seriously undercuts the argument that oil price rises are due to dollar decline, in whole or in part. As with any scientific experiment to determine causality, the non-correlation between March 10th and the present must be explained or the entire dollar-oil theory falls apart. I realize that it might be beyond the attention span/sound-bite requirement for most media to discuss this, but it certainly could be addressed in a newspaper or magazine article. I have seen neither. I'll keep thinking about it, but if there are any theories that people would like put to the test, please comment!


Eldridge Cleever said...

It is time to drill for oil in the US!

Jennie said...

Hawt. Seriously. Thank you. I have been arguing with people for weeks that oil prices can't be tied totally to the falling dollar, I just didn't have the economic know-how to argue it properly. Thanks for doing the number crunching.
Here's a question, do you see oil being sold in a different money denomination any time soon? i.e. Yen or Euros?

Jeff Vail said...

I think that we're gradually--very gradually--moving away from the petrodollar system and away from the system of dollars as the world reserve currency. I think that, a decade from now, there will be rough parity between sales of oil in dollars, in euros, and in a basket of currencies or in a commodity-weighted basket of some sort. Things like the opening of the Iran oil bourse that will trade oil futures in Euros will further that, but we're certainly not there yet. It's always been possible to buy oil in non-dollars, and some producers are actively pursuing this, but it is still difficult to trade oil futures and options in non-dollars. This isn't a huge hurdle--you can just trade oil in dollars, sell a dollar/euro or dollar/yen future to hedge against currency fluctuations, but this isn't quite as clean or quite as flexible as just trading in your own currency. So I think we'll move away from it in time. The bigger issue is the broader petrodollar system that encourages re-investment of dollar-denominated oil revenues in dollar-denominated markets (or, another example, IMF loan repayments that must be in dollars), and we'll probably move away from that system as well in time, but probably even more slowly. Just my take--this topic can go on for pages and pages...

Anonymous said...

No more M3 reports but evidence points to astounding money supply growth of late. The 'invisible hands' are keeping USDX in your channel,... or on the cliff... (see Norcini's nightly charts on JSMineset) For once the media gets it right, off message though and that reveals too much about our $ printing efforts. So now time to focus CFTC attention on speculators as the real bogey men.

kollapsnik said...

Maybe the dollar index is the wrong measure to look at, because it doesn't necessarily capture devaluation of paper assets in general, just relative to each other.

How about looking at the (now top secret) M3 money supply measure instead?

Jeff Vail said...

The St. Louis Fed still publishes MZM (Money of Zero Maturity), which I think is the most similar statistic to true M3 still available. I've written about this in the past--I guess it's time for me to dig up the link and compare the two...

Anonymous said...

"I don’t believe it is mere coincidence that crude has posted about a 30% y-t-d price surge at the same time as international reserve positions have expanded at about a 30% annualized rate - to a stunning $6.769 TN. Over the past 4 ½ years, official international reserves have ballooned an unprecedented $3.921 trillion, or 138%. During this period, crude prices surged almost 300%. Chinese reserves ballooned more than four-fold over this period to $1.68 Trillion; India’s reserve position tripled to $303bn; and Brazil enjoyed a four-fold increase to $189bn. After beginning 2004 at $73bn, Russian reserves have almost reached the half Trillion mark ($493bn). And in just the past year, OPEC reserves have inflated 42% to $490bn. To be sure, the world is awash like never before in excess “liquidity” for which to bid up prices of critical tradable resources." - from A New Inflationary Epoch by D. Noland located in Credit Bubble Bulletin section of May 9

Anonymous said...

Financial relativity is hard to grasp. Units such as Euros, Dollars, Yens, Pounds…. They all exchange with very little resistance and restraint. Jeff thanks for the graph. My view is the dollar has long lost its position as a reserve currency. The unit currencies are like the projected picture of the wizard from the Oz film. Nothing to it. It’s just one giant global pool of capital which for the most part flows like water. Very little resistance less than 1% transaction costs. Below the likely momentary price of any cross between units, shares, currencies, commodities, goods, services, rights, obligations, credit card balances, swaps, switches, pork bellies… our trust each morning on rising that our counterparty will fulfill their obligation. I log into my Mutual Fund Company or bank and they list the unit of money, fractional ownership of pools of other ‘assets’ and it has reality. A few clicks and a day later a balance moves to my bank. Go to a store, credit card swipe and they give me what I want based on other units and current prices. For what is said on squawk TV is pure ferry tales I have long turned it off. The price of gas at $10 a gallon is still a bargain, that persons made stupid choices is their own fault. (Drill USA -- Drill all you want, artic drilling, hay they are digging mine shafts in PA but increase daily global supply likely not.)

Jeff Vail said...

D. Nolan's entire analysis at PrudentBear is predicated on the assumption that it's possible to "bid up" the price of oil because you have extra money to throw around. I think this assumption is faulty, and therefore so is all of his analysis.

You CAN bid up the price of oil if you A) use that extra money to CONSUME more of it, or B) use that extra money to physically store more of it. Otherwise, you can only bid up the paper market, which is a DERIVATIVE of the spot market, and will eventually be pulled back in line with the spot market. I think this is exactly what we've seen with the little price correction on NYMEX in the two weeks...

Another, general comment: I think that there IS a causal relationship between dollar and crude--I don't want this article to be taken as my position to the contrary. I think this relationship is especially strong in short-term trades. Look at the graph above and you can see a high incidence of short-term correlation. What I don't think exists is a STRONG, long-term causal relationship (though most likely some kind of causal relationship over all time-periods). I think that the system is just too complex, too non-linear to reduce it to a simple, two-factor equation like "dollar down, oil up."

Robin said...

The Oil Price rise is related to supply.

When the supply of a non-essential item such as movie / ball game tickets or fine art statuary / paintings goes down, even a slight rise in price can depress demand substantially, bringing demand proximate to supply.

The same is not true of an essential item like food, where a shortage - driven rise in price will not dampen demand, since people will cut everything else to the bone to continue to acquire food. As a consequence the price rise will have to be more drastic to force down demand.

Petroleum products, while not quite as essential as food, are in the present world set-up fairly close. Hence a decrease in supply will severely boost prices.

This was even more so, since it did not effectuate demand destruction in a number of Asian countries due to government support of the consumer by a subsidy: the government absorbed the rise in price.

With those governments allowing a small price rise in petroleum products recently, it may cause a slight demand destruction, and provide a brief respite from a continuing rise in the petroleum price.

Anonymous said...

In the last 6 years, the value of the dollar has lost almost 30% of it's value. If you have assets in dollars and do nothing, the continued loss of value of the dollar will result in your loosing more asset value.
Unless you are sleeping or stupid, you are going to move your investments out of dollars to something with the ability to maintain it's value.
I thought about investing in other currencies, but foreign exchange investments are risky and have a fairly large tax associated with them.
If I invested in Gold or other precious metals, that would have a large amount of risk associated with it.
Investing in oil seems a natural. We will always need oil. The price of oil for the last several years has gone up and not down.
When was the last time you heard of Washington, or Bush-Cheney, doing anything real to actually lower the price of oil?
Therefore investing in oil commodity futures seemed like a sound safe solid investment with minimum risk.
That is the logic that is causing the price of oil to go up so fast.
For the last 6 years, the U.S. has been printing large amounts of dollars to pay for the war in Iraq. Printing large amounts of dollars causes the value of the existing dollars to go down.
The U.S. has done little or nothing in the last 6 years to keep the value of the dollar up. As a result, imports cost more and investors are forced to move their investments out of dollars, or watch the value of their investments loose value. Unfortunately investing in oil futures has less risk than many other alternative investment strategies.
Tragically this movement of investment from dollars to oil commodity futures is having a devastating effect on our economy.
Seems like utter incompetence is a job requirement for many federal jobs these days.
No doubt China and India's growing demand for oil is also driving up prices, but anyone that thinks China and India just came into existence needs to see a shrink and lock up their house to keep the aliens out.

Jeff Vail said...


Interesting that you should comment on government subsidies and their impact on demand--this is the topic that I'm currently writing about, probably for two Mondays from now. Bottom line--I think that cutting subsidies will create a slight reduction in demand, but no where near proportional to the cut in subsidies, and in select cases may actually increase long term demand. Stay tuned for why!


I disagree with your arguments. Take a look at this graphic:

Over the past few years, the increase in "investment" and "speculation" in oil has almost exactly tracked the commercial value of oil consumer--that is, there has been no flight to oil. It's a prime example of looking at correlation and claiming you see causation, when there is in fact no inferential link to suggest causation.

Second, as I've discussed here at length before, even if there is a flight of assets to oil, that isn't what is driving up the price. By the very economic definition of "price," it's set by the consumer's ongoing willingness to pay at these levels. It has very little to do with failure in Washington, or of "Bush-Cheney," but rather the resiliency of demand in light of tight supply.

That said, I'm not saying that oil won't continue to be a good investment, but if your intent was to hedge against the falling dollar, you could just use put options, rather than incur the ADDITIONAL risk of bringing oil into the equation. The tax ramifications (that is, if you're in the US) are virtually identical to investments in oil*

*not for long, though, if I have any thing to say about it... more on that in the coming months.

Anonymous said...

I have not bought oil futures, and do not even know the process to buy them.
My previous comment was simply... as the dollar goes down investors will want to convert dollar assets with something with more "real value". That in my opinion is simply one of the contributing factors leading to the increase in the price of oil.

Jeff Vail said...

I agree, and I think that investors are probably wise to do so. However, I don't think that it's a contributing factor in the price of oil. Speculative money can't raise the price of a deliverable commodity above what the end consumer is willing to pay, otherwise the speculator must eventually eat that difference. If the consumer is willing to pay the price, then that's just the standard supply/demand equilibrium point, not the result of any speculative bubble. This wouldn't be the case if there was actual, physical hoarding of oil (as in when the Hunt Bros. tried to corner the silver market), or where there is not a fixed delivery point, as in speculative housing bubbles, but neither of those are issues with oil (hoarding could be, but inventories are not increasing at the present).

Anonymous said...

How about the fact that the market is expecting that this administration will be involved in a skirmish with Iran before its end-term in office? The causes of these price increases are quite probably due to: 1)dollar fall 2) expectations of military intervention in Iran 3)fears that we have hit Peak Oil levels. But to be more sure, you should look at the correlation of the Euro and oil prices vis-a-vis that of the dollar and oil prices. You will be able to prove then that, in large measure, the increases in oil prices, are indeed, due to the dollar's fall.

Anonymous said...

The Wall St. Journal has an article which shows an almost perfect correlation between the Fed Funds rate and the price of oil.

Go to:

fdg said...

I like your blog. Thank you. They are really great . Ermunterung ++ .
Some new style Puma Speed is in fashion this year.
chaussure puma is Puma shoes in french . Many Franzose like seach “chaussure sport” by the internet when they need buy the Puma Shoes Or nike max shoes. The information age is really convenient .

By the way ,the nike max ltd is really good NIKE air shoes ,don’t forget buy the puma mens shoes and nike air max ltd by the internet when you need them . Do you know Nike Air Shoes is a best Air Shoes . another kinds of Nike shoes is better . For example , Nike Air Rift is good and Cheap Nike Shoes .the nike shox shoes is fitting to running.

Spring is coming, Do you think this season is not for Ugg Boots? maybe yes .but this season is best time that can buy the cheap ugg boots. Many sellers are selling discounted. Do not miss . Please view my fc2 blog and hair straighteners blog.
.thank you .

I like orange converse shoes ,I like to buy the cheap converse shoes by the internet shop . the puma shoes and the adidas shoes (or addidas shoes) are more on internet shop .i can buy the cheap nike shoes and cheap puma shoes online. It’s really convenient.
Many persons more like Puma basket shoes than nike air rift shoes . the Puma Cat shoes is a kind of Cheap Puma Shoes .
If you want to buy the Cheap Nike Air shoes ,you can buy them online. They are same as the Nike Air shoes authorized shop. Very high-caliber Air shoes and puma cat shoes . the cheap puma shoes as same as other.

polo shirts

ralph lauren polo shirts
chaussure puma

chaussure sport

chaussures puma

puma CAT

ed hardy clothing

ed hardy clothes

ed hardy womens

ed hardy sunglasses

fdg said...