Chicken and Egg: A Currency Called the Oil/Dollar?

The old “Which came first: The chicken or the egg ?”debate has turned into “Does oil effect the U.S. Dollar or does the Dollar strength (or lack thereof) drive oil prices?”

Here’s both sides of the story:

Option A: Oil is driven by supply and demand – Economics 101. Sure, there are speculators floating around, but certainly not prominent enough to drive the price of oil more than a few dollars either way. Oil prices react to socioeconomic events, conflict premiums and EIA data, among others.

Therefore, as demand increases, other countries (namely, the BRIC: Brazil, Russia, India, China) bid up the price and force oil to be valued at X amount of dollars in the eyes of the U.S. citizen/investor. In terms of companies that use the oil, like airlines, the smartest ones have had a hedge on prices for years.

Solutions: The government needs to look for both alternative energy and drill offshore to create our own extra supply. Citizens should demand congress to enact legislation promoting the use of nuclear power. Democrats argue that leaving Iraq would help lower prices (probably true, but should not be considered before we win the war). Other, in my opinion, less effective arguments include Sen. Obama’s call for a bigger reliance on the mass transit system.

Conclusion: Oil drives the Dollar.

Option B: I could not think of a better way to put this, so I’m using a quote I found in this FOREX Blog:

“In a nutshell, this inverse relationship exists because global oil prices are denominated in dollars. Thus, as the USD declines, oil producers are paid fewer 'units' of foreign currency in exchange for oil. They must compensate for this decline in real revenues by raising the price of oil (in dollars).”

To add to that, the price of physically importing the oil from foreign countries increases.

Solutions: Raise Federal Funds rates while growing the economy - the Fed’s dual mandate (FYI, the ECB has a single mandate). If China and others would float their currency, the USD would strengthen versus the EUR.

Conclusion: The Dollar drives oil prices.

Clearly, we see an inverse relationship from the weekly closing charts of the Dollar Index and Lt. Sweet Crude, respectively:

Comments

[Saul Sterman:]

Rule of thumb:
"Each 1% change in the dollar as measured against a basket of currencies causes oil to correct by about $4 in the opposite direction. A three percent dollar appreciation would result in oil coming down by $12."

Nothing has changed. I have been posting this since late 2006. Basically, the price of oil in dollars follows the dollar; true since oil hit the 60 level which is supply/demand based.

Price levels over 60 is currency devaluation which in turn creates global inflation which can feed upon itself for quite some time.
I'm not going to rehash here all the articles I have written on the topic.

The bottom line is that the next time we see oil at 140 it could be fundamental and NOT due to currency devaluation. In such case the price increase sticks until new technology that can substitute oil is proven to work (and implemented).

Saul Sterman

2008 Aug 10 07:18 AM

[whisperonth...:]

As long as one only considers medium and large cities, mass transit is a workable idea. The problem is that many more of us live in areas where even the option is not available at a reasonable cost. If the rail system currently in place were expanded and used for commuters, the air industry would be eased, and fuel needs reduced. But the rest of us drive cars 10 to 50 miles each way to work, and the option of moving closer is either not financially workable or not personally desirable. Given that, we need to fix both the dollar and the oil situations so that we have energy now and funds to explore other options in fuel/energy. To assume these are things that can wait would be foolish.

2008 Aug 10 08:26 AM

[CLH:]

Steve--very good post which gives both sides. I agree with Saul. Its both but the dollar is most important.

Whisper didnt answer the question. Wake up Whisper.

2008 Aug 10 10:13 AM

[snakyjake:]

If you wanted to lower prices, it isn't just about supply vs. demand. You can easily lower prices by eliminating profit. Sure, profits are good so it encourages future investment....but what if they won't or can't invest in the future?

2008 Aug 10 10:14 AM

[mixter:]

Did you say you want to eliminate profit, comrade?

Go to Russia or China with your buddy Obama!!

2008 Aug 10 10:33 AM

[snakyjake:]

Don't have to go to Russia or China....the U.S. people want something called "windfall profit tax". Which is just another way of taking excessive profits away from corporations. Same with increases in capital gain taxes, and other taxes.

2008 Aug 10 10:55 AM

[searcher:]

Ah, come on, don't be coy. Isn't any profit a 'windfall'? Since it exceeds the cost of labor and other 'minimally' relevant considerations such as the cost of capital and innovation and distribution, then it must surely be an unwarranted extortion.

2008 Aug 10 11:12 AM

[henarl:]

snakyjake: "The U.S. people want something called windfall profit tax" - really? On all corporations or just oil? Or any others that are temporarily unpopular? What percentage of corporate profit do you consider excessive? What about privately owned companies - shoud they be subject to "windfall profit tax? More corporations will simply move their operations to other countries that don't have "windfall profit tax" resulting in the loss of even more jobs here in the U.S. Good thinking!

2008 Aug 10 11:29 AM

[americanbands:]

Steve, Sounds like you are a supporter of the Bush/McCain propaganda policies.

Do the Oil companies, not already have, thousands of hectors, of government land to explore and drill. Are they saving these for Real estate speculation??

As for your comment of "...Oil is driven by supply and demand – Economics 101. Sure, there are speculators floating around, but certainly not prominent enough to drive the price of oil more than a few dollars either way..."

Perhaps it's time for you to go back to the 101 class as you must in denial..

"....The lack of response to an actual (if minimal) threat to supply support the thesis I have put forward here at TodaysFinancialNews.co... for months, and most recently in a Smart Investing interview with Krista Das: Prices had nothing to do with supply and demand. The lube-job on oil was performed mostly by speculators, not traders. Desk-jockeys who don't really have the wherewithal to make an honest living trading oil... but who moved markets and commodity prices by electronically allocating assets to the commodity that promised the easiest reward...."

seekingalpha.com/artic... .

MHO

2008 Aug 10 11:50 AM

[User 231885:]

It is hard for anyone to predict anything about spot oil in the short term due to the constant flux in the geopolitical landscape. However, long term, if and until alternative energy is a near reality, cheap oil at sub-100 prices cannot be sustained for two reasons. There have been no major discoveries in decades and many mature fields are approaching "peek oil" - moreover, as long as the oil bourse is tied to US $, the Dollar cannot sustain a rally as long the FED keeps printing billions of dollars a day to finance our trade and budget deficits exacerbated by a financial meltdown that is only half done. Beyond the psych games played by Bernanke and Paulson, no country has ever been able to print its way of a fiscal dilemma. Look for a huge breakdown on all fronts and stay short the market.

2008 Aug 10 12:20 PM

[FilipeAlves...:]

A currency called Dollar/Oil may be a first step to reduce printing billions for a finantial-tsunami.
We need the personalized money and the personal bank-finantial power proposed by the money datevaluation into Economy 4G3W.
Go to the uppgrade of the Old Classic Economy.
Regards/FilipeAlvesFer...

2008 Aug 10 02:38 PM

[Pretzel Logic:]

Snakyjake:

The only American people who "want" a windfall profit tax are the ones who have no grasp of economics. We tried this "windfall profit tax" in the '70s and it didn't work then -- it lowered oil production, which in turn raised oil costs. When will you people get it? THERE IS NO FREE MONEY. A windfall profit tax on American oil companies is a tax on ALL AMERICANS.

Exxon had a record profit, yes. They will also be paying a record TAX BILL (even without your "windfall" tax). Exxon by themselves will be paying more taxes than the bottom 50% of all American taxpayers combined. And you want to punish them for this? Study after study confirms: higher taxes = LOWER government revenue. Lower taxes = more productivity, more investment back in the business, more income = MORE government revenue.

Obama is an economic idiot. He's basically a Marxist -- and every Marxist economy has failed. What makes you think a Marxist America would be different? Obama's policies would fail spectacularly here just like they have everywhere else they've been tried.

2008 Aug 10 03:20 PM

[freefall51:]

The oil industry is doing a absolutely vital job to support this society. That said it is clueless at best and disingenious at worst to tell the people that soaking the oil industry with a windfall tax will do any good. If the oil industry as a body is subject to an additional tax in the same way none of these companies will have a competitive advantage or an incentive to eat that tax. Instead they will pass it onto the people with the following effects:

1.) The prices for oil products will go up for everybody
2.) The oil companies will sell less, which partially will offset the additional tax
3.) The oil companies will have less funds to invest in their business (linked and supported by other peoples business), hire employees (some people) or distribute earnings to their shareholders (again the people).

There could not be a more stupid way to set the economy up for failure and betray the people's interest. The only guys that really will profit from this short term are the proliticians that sell this nonsense. Politics should only be concerned what they need to do to let business (of all sorts) thrive rather than trowing stumbling blocks.

If an industry is smart enough to make money it should also be smart enough to spend it. It does not take any no-value-adding polititician to do that for them. Disgusting, in my not so humble opinion.

2008 Aug 10 04:44 PM

[PK de C'ville:]

@Mixter

Who needs the Obama slam? It's so idiotic...

Some might say that McCain's mother wore combat boots, but that too, would be idiotic.

Get my drift, comrade?

2008 Aug 10 05:15 PM

[farmerfloyd:]

Heh Snakyjake, How come nobody is asking for a windfall tax on Microsoft or Apple? They make 8% on there money invested and the oil cos only make 4%, they just have a LOT more money invested.
You want me to pay a windfall tax on my 10,000. in a savings accout and you with 5,000. because i make more money then you. Come on get educated. There are many cos making more money then the oil co,s per dollar invested.

2008 Aug 10 07:19 PM

[veryold:]

picky, but a smart fellow such as you needs to learn the difference between effect and affect

2008 Aug 10 08:54 PM

[azcaballer:]

If you want to get rid of the "corporate profit problem?" Get rid of the corporations tax and make all their income flow through to the share holders. This will cause a very different form of doing business, because retaining earnings will be taxed at the individual holder level so all corporate decisions will be directly felt by their share holders. This will have the business effect of creating companies run by democracies not by the select few at the top. I suppose that we would see companies less focused on huge profits. It would be interesting to see what would happen.

I suppose companies would be run like most small companies are today. Maximizing useful investment to grow the overall value of the business and minimizing any reportable profit through this investment. I think you would also see more corporates open up here in the US to avoid higher taxes elsewhere. Lower taxes equals more profits and less need to pass those taxes/costs on to consumers.

Also people would be more likely to get involved with the movement to curb government spending to minimise their own personal tax as a cheque will have to be written when shareholders get to pay the tax that Corporates used to pay.

2008 Aug 10 09:41 PM

[Favre4:]

I didn't read another word after your Obama comments. If you desire any credibility, write like an informed and rational individual. I am not even a Democrat, but Obama's plan to combat oil prices can HARDLY be summed up with 'use mass transit.' That is laughable.

If you want to be taken seriously, write that way.

2008 Aug 11 05:23 AM

[dlaw:]

Option C: There is a huge bubble in every major futures market - commodity and currency - except treasuries and other sovereigns. Oil and the euro - the least game-able of all the futures barring, go up last.

Solution: Well, it retrospect it was better regulation, but now it is the popping of the oil bubble, although that's hardly a "solution" to anyone's problem.

Proposal: Duck.

Oil is headed to $75 and every major trader knows it. If demand is as bad as it looks, we'll be lucky - that's right, "lucky" - if it stops there.

On the political front, elect John McCain and oil heads to $30 a barrel because there will be a Depression.

Elect Barack Obama and at least the country has a chance of avoiding a demand-pull deflation crisis.

2008 Aug 11 01:12 PM