From July 2014 to March 2015, the US Dollar Index rallied by 26 percent, reflecting the greenback’s strength relative to the currencies of key trading partners such as the EU, UK, Japan and Canada.
Over roughly the same time frame, the price of Brent crude oil tumbled by 54 percent, while West Texas Intermediate (WTI) crude oil gave up about 60 percent of its value.
Since mid-March 2015, the US dollar has pulled back slightly relative to most major currencies and crude-oil prices have recovered from the low hit in 2015.
These trends have prompted some pundits to assert that recent movements in crude-oil prices primarily reflect fluctuations in the US dollar’s value as well as central bank policy and relative bond yields.
Conspiracy theorists also like to argue that moves in crude-oil prices have little to do with supply and demand conditions in the global oil market.
This dangerous simplification appears to have gained currency in the mainstream financial media, where commentators frequently attribute strength or weakness in oil prices to moves in the US dollar.
The strong inverse correlation between the greenback and WTI in part reflects the fact that the commodity is priced in US dollars; when Uncle Buck gains strength relative to international currencies, buyers need fewer dollars to buy the same volume of oil.
However, the idea that fluctuations in the US dollar’s value drive global energy prices requires some heavy-duty blinders and a cultivated aversion to cognitive dissonance. Unfortunately, the global oil market involves far more complexity.
WTI prices fell by about 60 percent between July 2014 and March 2015, but the US Dollar Index rallied only 26 percent; on this basis, the upsurge in the US dollar’s value explains less than half the drop in crude-oil prices.
Moreover, the price of Brent crude oil—an international benchmark that better reflects global supply and demand conditions than WTI—has declined sharply in terms of the euro, yen and even gold prices.
This across-the-board drop in crude-oil prices reflects a decline in the commodity’s real value, not the vagaries of international currency markets.
And extending the purview of our analysis beyond the past 18 months reveals plenty of instances where the US dollar and crude-oil prices didn’t follow this simplistic inverse correlation.
Between November 2011 and February 2012, for example, the US Dollar Index climbed by about 7 percent and crude-oil prices soared more than 40 percent. And when the US Dollar Index rallied by about one-third between late 1998 and mid-2001, crude oil prices also climbed from a low of about $10 per barrel to more than $37 per barrel.
An analysis of monthly data from the past 35 years reveals a statistically significant inverse correlation of negative 0.205 for the US Dollar Index and crude oil, suggesting that they move in opposite directions over the long term. However, the magnitude of this correlation suggests that currency markets can only account for some of the moves in crude-oil prices over the past 35 years.
Bottom Line: Although a strong US dollar can influence oil prices, other drivers hold more sway over the price of this global commodity.
Check out this graph plotting the year-over-year change in oil prices and US inventory levels since 1991. As you can see, larger inventory declines tend to be bullish for crude-oil prices; reduced stockpiles imply a tightening in the supply-demand balance.
The opposite also holds true. Over the past 52 weeks, US oil inventories have soared to the highest level since the 1920s—and crude-oil prices have dropped by almost 50 percent. This glut of crude oil, coupled with the upcoming turnaround season for many refineries, forms the cornerstone of our case for another leg lower in crude-oil prices.
The trend line we fitted to the data on this graph has an R-squared value of about 0.32. (R-squared measures how closely the line fits the data points on the graph; higher values indicate a closer relationship.)
And the year-over-year changes in WTI prices and US oil inventories (excluding those in the Strategic Petroleum Reserve) exhibits an inverse correlation of negative 0.56.
By comparison, the year-over-year change in WTI prices and the US Dollar Index exhibits an R-squared of 0.135 and an inverse correlation of about negative 0.36; inventory levels exert more of an influence over crude-oil prices.
But the weekly inventory statistics from the Energy Information Administration aren’t the be all and end all of forecasting movements in crude-oil prices. Inventory levels are one of the many fundamental drivers we consider when formulating our outlook for oil prices. (We’ll update our forecast and its implications for our investment strategy in the next issue of Energy & Income Advisor.)
Beware pundits who justify moves in WTI prices by citing fluctuations in the value of the US dollar; a simple story may be easy to understand, but we live in a complex world.
Elliott and Roger on Dec. 30, 2021
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