How Does the Weak Dollar Affect Oil Prices?

Around the world, there is anguished hand-wringing about the high price of oil. But if political leaders and policymakers want lower oil prices, they should be promoting policies that strengthen the dollar.

Around the world, there is anguished hand-wringing about the high price of oil. But if political leaders and policymakers want lower oil prices, they should be promoting policies that strengthen the dollar.

The implications of pricing oil in any single-currency are more far-reaching than most people think. For example, some oil-producing countries ask their customers to pay in euros, but that does not mean that their oil is priced in euros. And even if dollar prices were to be replaced by euro prices, the impact of single-currency pricing on the oil market would be the same.   

While oil-exporting countries receive revenues in dollars (or their euro equivalent), they use different currencies to import goods and services from various countries. Any change in the exchange rate of the dollar affects the purchasing power of these countries, and therefore their real income. 

Likewise, international oil companies sell most of their oil in dollars, but they operate in various countries and pay some of their costs in local currencies. Any change in the value of the dollar therefore affects their cost structure and profitability. In turn, it affects reinvestment in exploration, development, and maintenance.

The relationship between the value of the dollar and oil prices is very complex. While they can feed on each other to produce a vicious cycle, their short-term relationship is distinct from their long-term relationship.

In the short-term, dollar depreciation does not affect supply and demand, but it does affect speculation and investment in oil futures markets. As the dollar declines, commodities – including oil – attract investors. Investing in futures becomes both a hedge against a weakening dollar and an investment vehicle that could yield substantial profit, particularly in a climate of vanishing excess oil production capacity, increasing demand, declining interest rates, a slumping real estate market, and crisis in the banking industry.

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OPEC might be correct to blame American policies and speculators for higher prices. It is also correct that if OPEC had excess capacity, it would have already used it to flush out speculators to bring oil prices down. OPEC can regain control in one of two ways: use its “claimed” excess capacity to flush out speculators, or use its financial surpluses to overtake them. Recourse to the latter option means that, even without excess capacity, OPEC can still be in the driver’s seat.

In the long run, however, statistical analysis of various oil industry variables indicates that a weaker dollar affects supply by reducing production, regardless of whether oil is owned and produced by national or international oil companies. A weak dollar also affects demand by increasing consumption. The result of a decrease in supply and an increase in demand is higher prices.

The lower dollar also reduces the purchasing power of oil exporters. If nominal oil prices remain constant while the dollar declines, the real income of the oil-producing countries declines, resulting in less investment in additional capacity and maintenance. The same is true of oil companies. Consequently, oil prices increase.

Indeed, because oil prices were rising while the dollar was declining, capacity expansion by oil firms failed to meet forecasts for non-OPEC production in the last three years. Even oil production in the United States has not matched the increase in oil prices, as rising import costs for tools and equipment – partly a reflection of the dollar’s weakness and other factors – have forced project delays and cancellations.

Of course, the lower dollar means cheaper oil in Europe, Asia, and all countries with appreciating currencies. Oil prices hit records in the US in 2004 and 2005, but not in Europe, which partly explains why economic growth there has not been affected. When Americans paid $120 per barrel, Europeans paid only about €76 per barrel.

Several factors have prevented high oil prices from affecting the demand for petroleum products in the US in recent years, such as increased government spending, low interest rates, tax breaks, and an increase in real incomes. To be sure, the weaker dollar has forced some American families to spend their vacations in the US instead of Europe. But, since many Americans use gas-guzzling SUV’s for their vacations, demand for gasoline has remained high.

Unless and until US consumption patterns change or a rebounding dollar increases oil production, Americans will bear the brunt of single-currency oil pricing.