Wednesday, June 11, 2008

Dollar and oil

The media and most mainstream economists will have you believe that there is a link between the weak dollar and the price of oil The fact of matter is, there is no link whatsoever. The price of oil is dictated by one thing: supply and demand.

The current, $135 per barrel price is there because demand is higher than supply, pure and simple. That would be the case whether the price of oil were quoted in euros, yen, renminbi, British pounds, or any other currency. Even if the price of oil were quoted in Beanie Babies, it would still take the equivalent of $135 worth of Beanie Babies to buy one barrel because of supply and demand factors. (I'll leave aside the discussion of demand for now--whether it's real demand, i.e. related to what is being used for consumption, or investment demand, which is where a good chunk of the "new" demand is coming from.)

Many mainstream thinkers believe that the rise in oil prices has to do with the Fed or U.S. Government fiscal policy. It doesn't. A falling Fed funds rate and a fiscal deficit did not create a global shortage of oil. It's true, however, that both may be contributing to slightly higher levels of demand but not enough to explain the current price.

If a weaker dollar has been an outgrowth of the Fed's monetary policy, that, too, has not been responsible for the rising price of oil. Case in point: Oil quoted in euros has risen too, even though the euro has doubled in value against dollar in the past six years and the ECB maintains relatively tight monetary policy. Moreover, in other countries where monetary policy has been restrictive, such as China, oil prices are on the rise as well.

In fact, one could argue that a declining dollar is actually bearish for oil. Since oil is quoted in dollars and the United States is the world's biggest oil consumer, a decline in the dollar, by definition, would mean that U.S. purchasing power is reduced and therefore, less oil is consumed, putting downward pressure on the oil price. If I am the biggest collector of Beanie Babies in my neighborhood and I suddenly experience a big loss to my income, the price of Beanie Babies should not rise. If anything the price should come down or stay the same. Same thing should hold true with oil, but it doesn't.

Some might conclude that while the U.S. would experience a loss in purchasing power because of a decline in the dollar, other countries would simultaneously gain purchasing power (as other currencies appreciated vis-a-vis the dollar), enabling them to buy more oil. This is true, but the net change in demand due to currency adjustment would be zero, so there should be no price effect. Oil has, however, continued to climb.

To repeat: prices are determined by supply and demand and demand trends related to exchange rates (as opposed to economic growth rates, investment, etc) have no net effect.

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