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

Includes: OIL, UDN, USO, UUP
by: Steve Farrington

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:

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