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Oil prices and changes in EUR/USD
Oil Market Update
A challenging week for EUR/USD and oil prices, how strong are the spill-over effects?
Direction of change between oil prices and EUR/USD important, but not clear cut
Real oil price changes may cause changes in the real exchange rate, but little proof of the opposite
A challenging week for EUR/USD and oil prices
A tug-of-war between negative news from Europe and the US over debt problems, budget talks, the debt ceiling and the possibility that the rating agencies will downgrade US debt has pulled USD/EUR in opposite directions this week. The lack of agreement on both sides of the Atlantic Ocean has raised concerns about the impact a failure to reach a consensus will have on financial markets and economic growth. Optimism has increased somewhat before today’s European emergency summit in Brussels after Germany and France agreed on a new rescue package for Greece yesterday. Also, a deal to increase the US debt ceiling and cut the deficit seems to be within reach as the US president backed an agreement among a group of Democratic and Republican senators. The changes in risk appetite prompt investors to offload risky assets such as equities and oil and move into safe havens such as the USD and gold. Changes in investor attitudes towards risk can cause short-term fluctuations in EUR/USD and oil prices.
The IEA has set a deadline for Saturday 23 July whether the agency will once again draw on strategic inventories to increase the supply of crude and oil products to the market. If the agency decides to go for a second round of stock draws, we expect oil prices to drop.
Crude oil and many other commodities are priced in USD and periodically the correlation between changes in EUR/USD (or a USD index) and USD-denominated commodities is high, but it varies over time. If no obvious reasons can be found to justify the current changes in oil prices, one of the most frequently cited explanations used by financial reporters and analysts is changes in the USD. But is the relationship between the USD and the oil price changes really that straightforward?
Correlation changes over time
USD weakness in recent years is often cited as one reason for high oil prices, that is, a weak USD has pushed oil prices higher. OPEC has often used the weakening of the USD as a factor out of its control to explain why oil prices have moved above the cartel’s unofficial price target.
But the direction of the causality (the way a change may run) between the USD and the oil price is not clear-cut. Does a change in oil prices lead to a change in the USD or is it the other way around?
We can think of three transmission mechanisms that could underpin the argument that changes in the USD could lead to a change in oil prices.
The purchasing power channel
A weakening of the USD makes oil cheaper measured by other currencies than the USD or currencies linked to the USD, for example through a fixed peg to the USD. A weakening of the USD could therefore push up demand for oil for non-USD-linked countries.
But the purchasing power effect on oil demand has not been clear-cut. In Europe high taxes and duties on oil products have increased the prices to end- users. By contrast, in many oil-producing countries such as Venezuela and the Middle East and in large oil-consuming countries like China, oil product prices, especially for transport fuels, have been subsidised so changes in the exchange rate have not been fully passed through to end-users. Thus, a weakening of the USD did not lead to increased demand for oil in non-USD-related countries.
The cost channel
Oil producers’ budgets could be based on target export revenue from oil exporters. For example do we expect that large spending programmes for the OPEC countries in the MENA region implemented to prevent further uprising, have forced the cartel to raise its preferred unofficial price range to around USD 85- 105/barrel. A weakening of the USD could lead to a slower increase in oil production by OPEC to push up the oil price to compensate for the lower income measured in the national currencies of the cartel members.
The securities channel
The significant weakening of the USD during the autumn of 2007 and the spring of 2008 also contributed to reducing earnings from financial products invoiced in USD. The sub-prime crisis and a declining housing market were the main reasons why confidence in the US economy eroded, as did investors’ interest in the USD in the spring of 2008. Players in commodities markets, on the other hand, gained increasing confidence from what seemed an insatiable appetite for commodities from the emerging economies, notably Brazil, Russia, India and China, also known as the BRIC countries. This helped to make USD-denominated commodities more attractive as a financial investment class. Non-renewable resources such as oil also have a so-called own value and can thus seem a good investment choice or a hedge against inflation.
Causality runs from real oil prices to real exchange rates – limited evidence of the opposite
The above explanations seem plausible, but receive varying support from historical data. In contrast, by using several econometric techniques it seems to be well documented in the literature that the causality may run in the opposite direction, that is, from the oil price to the exchange rate, at least for real prices.
For example Chen and Chen (2007) indicate that a rise in oil prices depreciates real exchange rates in the long run. Their findings are consistent with the argument that a real oil price rise may increase the price of tradables relative to non-tradables in both the domestic country and in the US. If a domestic country is more dependent on imported oil than the US, the increase in the price of tradables relative to non-tradables in the domestic country would exceed the US increase and thus cause a real depreciation of the domestic currency against the USD.
Furthermore, Lizardo & Mollick (2010) suggest that oil prices significantly contribute to the explanation of movements in the value of the USD in the long run. They find that an increase in the real price of oil leads to significant depreciation of the USD relative to net oil-exporting countries such as Canada, Mexico and Russia. The rationale behind their finding is that in case of an oil purchase transaction by the US, from say Russia, a remittance of USD is made from the US importer to the Russian producer. The Russian company, which needs roubles to finance the costs of its Russian operations, sells the USD in the foreign exchange market for Russian roubles. As a result, the supply of the USD increases while the demand for Russian RUB goes up, all other things being equal. Consequently, the value of the USD relative to the RUB decreases.
Not much of the literature we have found has studied the links between the causation for the daily change in the Brent oil price and the nominal effective exchange rate. One exception is the study by Zhang et al, (2008). Although their findings suggest that for the period from 2002 to 2007, the USD was one important factor influencing the oil price trend in the long term (the effect reached a high after one year), the short-term influence of the USD was limited. Fundamental reasons for oil price changes such as supply, demand and expectations for the physical market balance are suggested as the driving forces in the short term, the impact of financial markets are considered to be limited.
External factors may influence both markets
Oil price movements and changes in the USD may also react to the same news and information. For example the publication of leading indicators or interest rate decisions can give useful information about the underlying growth momentum in the economy and thereby the expected future demand for oil. In addition, the release of information can also influence the risk appetite and trigger “sell-offs” or “buys” in the market. In turbulent periods with high uncertainty the USD is often used as a safe haven. Investors move their money from more risky assets such as oil and other commodities to the USD market and the USD will strengthen will oil prices will fall.
Conclusion:
Without any clear evidence that a change in the EUR/USD rate leads to a change in the short-term nominal value of the oil price (the causation runs from foreign exchange to oil), we will continue to base our assumptions on the view that a change in the oil price may influence the exchange rate more than the other way round.
Sources:
Chen, S-S and Chen, H-C (2007), “Oil prices and real exchange rates”, Energy Economics, Vol. 29, pp. 390-404.
Lizardo, R.A. and Mollick, A.V. (2010), “Oil price fluctuations and US dollar exchange rates”, Energy Economics, Vol. 32, pp. 399-408.
Zhang, Y-J, Fan, Y.. Tsai, H.T. & Wei, Y.M. (2007), “Spillover effect of the US dollar exchange rate on oil prices“, Journal of Policy Modelling.
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