Oil Investors Beware: Drawbacks Of The Dollar

| About: The United (USO)
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Oil and the dollar are related because trading is done using dollars.

The dollar does not directly influence the oil price.

There have been times when crude prices rose against a flat dollar.

Over time, oil has appreciated much more than the dollar due to higher demand for oil.

Currency depreciation is not accounted for, which also explains why the dollar has remained flat for decades but oil has surged.

There is no single scientifically proven way of analyzing crude oil (NYSEARCA:USO) (or anything else in the market for that matter), which is why we all have our own unique approach. However some investors are very adamant about sticking to a particular methodology, even though there are obvious drawbacks. Today I'm going to talk about why we shouldn't rely too much on the value of the dollar to evaluate oil prices.

The dollar is often attributed as the major cause for volatility in oil. There is no doubt that the dollar and oil are related. To value the dollar, we will use the dollar index, which reflects the dollar's value against a basket of major currencies. The chart below illustrates how the two assets have moved in the past. It's clear that there is an inverse relationship.

Since purchases and sales of oil are settled in dollars, inevitably they will have some form of connection. If the dollar sits perfectly still but oil prices shift, supply and demand would go out of sync. For example, if oil were to decline by 50%, buyers could purchase twice as much crude with the same amount of money (since the dollar didn't move), but suppliers would earn only half as much. Obviously such imbalance cannot exist for long, which is why the dollar typically moves in the opposite direction to compensate for this imbalance. As crude falls, demand for crude increases, and since the world needs dollar to buy oil, demand for dollar increases, leading to a higher dollar.

The principle also works in reverse. To buyers (suppliers), the total cost (revenue) consists of the dollar and the oil price. If one changes, the other should move in the opposite direction to maintain the equilibrium. For example, if the dollar rises, suppliers will earn more; so supply of oil will increase, driving down the price of crude. Similarly, demand for oil will decrease, which will also put pressure on crude.

Note the language in the above paragraphs, ultimately everything comes down to supply and demand. This may sound obvious, but it's important to understand this fact because there is no direct link between the value of the dollar and crude oil. Suppliers and buyers take the value of the dollar into consideration, but it is just one of the many things that they look at. To illustrate, the dollar was flat from 2009 to 2011, but oil rose sharply regardless. During that period, Saudi Arabia also boosted output by almost 2 MMbbl/day.

You can accuse me of cherry picking the data, but that is precisely the point: crude oil didn't track the movement of the dollar.

Another problem is that the dollar index does not take the increasing demand for oil into account (i.e. consumers are willing to pay more for the same amount). The graph below shows that even though the dollar index hasn't moved much over the past two decades, oil prices have risen significantly. So oil has gotten a lot more expensive, but consumers are willing to pay for it anyways, illustrating higher demand.

The chart above also shows another problem: the exclusion of inflation from the dollar index. Granted, this won't matter much in the short-term, but its impact will be felt given enough time. Because the dollar index measures the value of the dollar against other currencies, it only captures the relative difference in inflation between currencies throughout time. Since inflation is present in other parts of the world (until recently I suppose, i.e. a stagnating EU), the dollar index does not reflect the depreciation of the dollar's purchasing power, which is why we are seeing a much greater appreciation in crude over time.

All in all, the dollar could be a useful tool in one's analysis, but I believe that it's foolish to put too much emphasis on just a single factor. When we have the possibility of another supply war on our hands (read Oil Could Hit $30), I really don't think the dollar will play much of a role. Any correlation will be the result of the dollar responding to oil, rather than the other way around.

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