Oil Prices and the Value of the Dollar

Oil Prices and the Value of the Dollar

April 12, 2016
Oil Prices and the Value of the Dollar
Oil Prices
mechanism of the exchange rate, the value of the U.S.
Oil prices, as measured by the spot price of West Texas
dollar compared to the values of other currencies
Intermediate (WTI), achieved a level of $107.95 per barrel
worldwide.
on June 20, 2014. By March 14, 2016, the price of the same
barrel of oil had sunk to $37.20 per barrel, a decline of over
The U.S. dollar serves as a reserve currency for the world
65%. The fall in the price of oil was not continuous. After
economy. This means that most nations hold dollars to
the initial decline, oil prices seemed to have stabilized in
facilitate international trade, as well as a way to hold
the $60 per barrel range from April 2015 through June
wealth. However, the dollar’s value, computed as the
2015, but then began to decline again.
number of dollars it takes to purchase one unit of a foreign
currency, or a specified basket of currencies, varies almost
Figure 1. Spot Price of West Texas Intermediate Oil, continuously, reflecting world economic conditions.
2013-2016
Currency values are reciprocal, in the sense that when the
U.S. dollar rises compared to, say, the Japanese yen, this is
equivalent to saying that the Japanese yen has fallen in
value compared to the U.S. dollar.
Figure 2. Value of the Dollar, 2013-2016

Source: Energy Information Administration, oil price data. Graphic
by CRS.
Many explanations have been given for the decline in oil
prices. On the market fundamentals side, weak economic

growth, almost worldwide, was credited with reducing
Source: Federal Reserve Bank of St. Louis, exchange rate data.
overall oil demand growth. On the supply side of the
Graphic by CRS.
market, rapid growth of U.S., and other, non-conventional
oil supplies, as well as increasing production in Iraq, were
The value of the dollar as measured against a trade-
creating a supply glut, resulting in record amounts of oil
weighted index of major currencies began increasing in July
held in storage. With respect to political/economic factors,
of 2014 when the index measured 76.3729. By March of
the Organization of the Petroleum Exporting Countries
2016 the index stood at 92.9248, representing an increase of
(OPEC) declined to make production cuts that would limit
over 21%. With respect to the time trend, it appears that the
supply and potentially support prices. In addition, economic
value of the dollar began increasing soon after oil prices
sanctions against Iran appeared likely to be lifted,
began to fall in June of 2014, and continued to rise over the
potentially introducing even more oil supply into an already
period of declining oil prices, but by a percentage
over-supplied world market.
magnitude of only approximately one third of that of the
change in oil prices. This pattern of oil price and exchange
The Value of the Dollar
rate data suggests that exchange rates, while not
An additional factor affecting oil prices that received
precipitating the fall in oil prices, could be a factor in their
analyst attention during the oil price decline was exchange
continuing decline.
rates, or, in particular, the value of the U.S. dollar. The link
between the value of the dollar and the spot price of WTI is,
Exchange Rate Determination
for many, one of the more opaque factors in oil pricing.
The value of a nation’s currency depends on a variety of
economic factors related to the world demand for the
On the world oil market, oil is priced in U.S. dollars, and all
currency and the supply of the currency on the world
oil market transactions result in transfers of dollar balances.
currency market.
As a result, the United States is, in effect, an indirect
participant in all world oil trades through the use of its
Economic factors important in exchange rate determination
currency. This indirect participation occurs through the
include inflation rate differentials between countries,
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Oil Prices and the Value of the Dollar
interest rate differentials between countries, relative current
in the demand for oil, followed by a decline in the price of
account deficits, the levels of public debt, the terms of trade
oil which, at least qualitatively, negates the effect of the
(export prices divided by import prices), political stability,
increase value of the dollar on the oil market. As the price
and relative employment and economic growth
of oil declines, measured in dollars, demand is likely to
performance.
increase in the longer term.
The following three examples represent cases of changing
The same type of effect also works in the opposite
economic conditions resulting in an increased demand for a
direction. If the value of the dollar declines against other
nation’s foreign exchange, which likely would lead to an
currencies (other nation’s currencies appreciate),
appreciation of the currency. First, if inflation rates vary
purchasing the required number of dollars needed to buy a
between countries, this can lead to a changing balance of
barrel of oil declines. Oil appears cheaper, measured in
trade between the countries as the nation with the lower
foreign currency. This causes the world demand for oil to
inflation rate gains sales on the international market
increase, tending to increase the price of oil.
compared to higher cost producers. Second, higher interest
rates in one country compared to another can cause changes
During the oil price surge between the third quarter of
in international capital flows as investible funds seek the
2007, and peaking in July of 2008, the price of oil increased
highest rate of return, given the level of risk. Third,
by over 50%. During this period the value of the dollar
perceptions of lower risk associated with a nation’s
declined by about 4%. This behavior suggests that, at least
economy or political structure for a given rate of return
qualitatively, the inverse relationship between the value of
might also result in an inflow of international capital.
the dollar and the price of oil holds, both for appreciation
and depreciation of the dollar.
Oil Demand and the Exchange Rate
If the value of the U.S. dollar rises compared to other
A key factor in assessing the quantitative magnitude of the
nation’s currencies, this affects the demand for oil in those
dollar/oil price relationship is the sensitivity of the
other nations. Since oil is priced in dollars, those dollars
relationship between the quantity of oil demanded in the
must be purchased by oil suppliers in the foreign nation.
nations whose currency has depreciated against the dollar
Since the dollar has appreciated (the value of the foreign
and changes in the price of petroleum products measured in
nation’s currency has declined) a larger amount of domestic
the domestic currency. Empirical evidence suggests that
currency must be used to purchase the number of dollars
this value, called the elasticity of demand by economists, is
required to buy a barrel of oil. The effective increase in the
low. This implies that a given percentage change in price
price of oil, measured in domestic currency, is likely to
results in a less-than-proportionate change in quantity
result in higher prices for petroleum products in the
demanded, implying, when all countries’ demand are
domestic market as costs are passed on to ultimate
aggregated, a small change in the world demand for oil,
consumers. In general, the quantity demanded of a product
with small effects on the world price.
tends to decline in the face of higher prices. As a result, it is
likely that the demand for gasoline, diesel fuel, etc. in
Conclusion
foreign countries will decline when the value of the dollar
Although the qualitative relationship between the value of
increases.
the dollar and the price of oil is consistent, its quantitative
magnitude is likely not sufficient to explain, on its own, the
As the demand for oil declines in countries whose
price surges and declines observed in the oil market. Like
currencies have depreciated against the dollar, a decline in
many factors which go into determining world oil prices,
world demand for oil, or at least the growth in world oil
the value of the dollar is one, but not the only, factor.
demand, is likely. Given supply, a decrease in world
demand is likely to put downward pressure on the world
Robert Pirog, Specialist in Energy Economics
price of oil. As a result, one might conclude that an increase
in the value of the dollar gives rise to a short-term decline
IF10386

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Oil Prices and the Value of the Dollar

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https://crsreports.congress.gov | IF10386 · VERSION 2 · NEW