Rice University researchers link oil price to U.S. dollar

A striking correlation between the greenback and oil – and a record of dramatic change – emerged from a review of three decades of relationships

By Gordon Jaremko

December 01, 2009

Warm-up activity is continuing at a brisk pace for large-scale natural gas development in northeastern British Columbia.

B.C.’s October drilling rights sale alone fetched $370 million for 658 square kilometers of prospects. In the first 10 months of 2009, industry spent $701 million to scoop up B.C. gas targets.
Attention continues to center on shale and other “tight” geological formations. The dense rock is saturated with gas but can only be tapped by unconventional methods such as horizontal wells and aggressive use of high-pressure fluid injections to fracture flow channels into the deposits.

There is a simpler way to anticipate at least the direction of oil price movements than probing through murky, slowly accumulating data on supply and demand for the physical commodity, according to research by two Texas economists. Watch changes in the value of the United States dollar compared to other currencies. Then point the oil price arrow in the opposite direction. This rule-of-thumb barometer will be right 80 per cent of the time, they say.

A striking correlation between the greenback and oil – and a record of dramatic change – emerged from a review of three decades of relationships by Kenneth Medlock and Amy Jaffe, who are research fellows in the James Baker III Institute for Public Policy at Houston’s Rice University. There are neglected but “inescapable facts” about the parallel evolution of global energy and financial trading, the economists say.

Between 1986 and 2000, the correlation between oil prices and the value of the U.S. dollar compared to an index of other currencies was a statistically insignificant 0.08, report Medlock and Jaffe. That is, oil and the greenback moved in step only eight per cent of the time.

Since 2001 the correlation increased drastically to a highly significant 0.82, the researchers found. Oil and the U.S. dollar are simultaneously on the move 82 per cent of the time. The statistical yardstick is also consistently a minus quantity, meaning the two items go in opposite directions. When the American dollar goes down, oil goes up, and vice-versa.

The increased correlation has developed in tandem with a big change in the leading indicator of oil prices: trading in futures contracts on commodity exchanges. Speculators that have little or no direct involvement in oil production or consumption – a tribe known as noncommercial traders or financial players in polite official language – now account for about 50 per cent of commodity-futures activity. Prior to 2002, they drove only 20 per cent of trading on average. Oil suppliers and buyers used to dominate the exchanges, making them tools for setting up financial hedges against unpredictable price movements.

For an oil exporter country like Canada, the research of Medlock and Jaffe pinpoints a financial risk element in commodity prices. For a big importer like the U.S., which spent $331 billion on foreign oil in 2008, the research findings highlight twin perils to living standards: simultaneously rising costs and falling purchasing power.

“The threat to U.S. economic health and national security is that the dollar risks getting caught in a vicious cycle where continually rising oil prices feed the U.S. trade deficit, leading to increased U.S. indebtedness and thereby an even weaker dollar, which further drives oil prices higher,” the Texas researchers write.

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