The Oil and Dollar Link - BY PHILIP K. VERLEGER, JR.

The relationship between the dollar’s exchange rate and oil prices
has been debated now for decades. Oil-exporting countries justified
their first round of price hikes to $10 per barrel in late
1973 by blaming global inflation and the falling dollar. Oilexporting
countries again blamed the weakening dollar for the
second major round of price increases in 1978. Eight years later,
the dollar’s resurging value was cited as a cause of the 1986
price decline. More recently, oil prices and the dollar’s exchange
rate have seemed to move as one.
However, the mechanism that links the movement of oil prices and the dollar has
never been satisfactorily explained. Indeed, a credible explanation may never be
found. Certainly no one to date has advanced a convincing theory for their coincident
movement.
Yet the relationship clearly exists, particularly since 2007, as can be seen from
Figure 1. This graph presents the spot price of “Dated Brent,” the world’s crude oil
benchmark, against the left vertical axis and the dollar’s exchange rate against the right.
To paraphrase Bob Dylan, “You do not need to be an economist to observe the linkage.”
Why does one observe this linkage and what does it portend for the future? One
way to answer the question would be to construct a detailed econometric causality
study. If such efforts were made, I am sure one group of brilliant econometricians
would find a causal linkage which showed that oil price movements were caused by
changes in the exchange rate while a second equally brilliant group would find the
reverse. I do not propose to conduct this kind of examination, although I was once a
practicing econometrician. Instead, I suggest that recent coincident movements of oil
prices and the dollar’s exchange rate reflect declining confidence in the Federal
Reserve’s ability to contain inflation. Furthermore, I show that the rise in oil prices
over the last six months—particularly the surge since January 22, 2008—shares many characteristics with the rise in silver prices that occurred
from early 1979 to January 1980. This leads to a very
frightening conclusion: oil prices could be pushed to $150
per barrel or higher before the end of 2008.
RECENT OIL PRICE CYCLES
Of late, crude oil prices have followed a relatively predictable
cycle over the course of a year. The pattern is similar
to the cycle observed in agricultural commodities.
Crude prices rise during the spring and summer as gasoline
prices exert an upward pull on prices for “light sweet
crudes” such as Brent and WTI. These two crudes share
two key characteristics. First, they are the benchmarks for
trading in futures markets. Second, they have unique chemical
characteristics that make them particularly attractive
to refiners at times of peak gasoline and diesel fuel consumption.
For this reason, prices can be expected to rise
in the spring and summer and then decline with the
approach of winter as motor fuel use drops. The price
decline generally lasts until mid-January.
The cyclical pattern can be observed from Figure 2.
This graph shows the daily spot prices for Brent crude
(“Dated Brent”) from January 2004 through February 29,
2008. Vertical lines mark the price peaks. Note that these
occurred in August 2005, August 2005, and August 2007 as
expected. The peak in 2004 occurred later, in
October.
The price decline from August 2006 to January
2007 was particularly noteworthy. During this
period, the emergence of Wall Street commodity
investors provided a strong incentive to build stocks
(see my piece, “How Wall Street Controls Oil,” TIE,
Winter 2007). The rise in stocks drove cash prices
from a peak of almost $80 per barrel in August 2006
to a low of $50 per barrel in January 2007.
A fifth price cycle began less than a year ago. At
the end of July 2007, prices began to fall as they had in past years.
The decline can be observed in Figure 2.
However, in 2007 the period of price decline lasted less than
a month rather than the usual five months. Oil prices began
to move higher in late August, peaking at $97 per barrel in
early January 2008. (WTI touched $100 at that time.)
The high prices, however, were unsupportable in
January and prices dropped by more than 10 percent. Prices
would likely have fallen much further through February.
However, events in financial markets on January 21, 2008,
brought the decline to a halt. Crude again surged, finishing
February above $100. As the year progresses, it will likely
rise much further.
CAUSES OF THE 2007/2008 SURGE TO $100 PER BARREL
Two factors explain the rise in oil prices to $100 per barrel
over the last seven months. These are a physical squeeze on
the available supply of light sweet crude and the ongoing
financial crisis, which has forced the Federal Reserve to
abandon, at least temporarily, its focus on price stability.
The squeeze on light sweet crude began in mid-August
2007, as did the first round of the current credit crisis. At
that time, the U.S. Department of Energy announced its
intention to resume filling the Strategic Petroleum Reserve
and then began to remove light sweet crude from the market.
DOE’s action created consternation in crude markets
and sent light sweet crude prices spiraling upward. The
price increase would not have occurred had DOE decided
to put only sour crude in the Strategic Petroleum Reserve.
Markets were vulnerable to DOE’s actions because
sweet crude supplies are limited and because sweet crudes
are the critical ingredient for production of ultra-low-sulfur
diesel fuel, the product refiners now must supply to consumers
in the United States, Europe, and Japan.1 Refiners
can produce the low-sulfur diesel products more easily with
sweet crudes. DOE’s curious decision to remove even modest
amounts of these crudes from the market contributed
to a sizable price increase.2
The global financial crisis that began in August provides
the second explanation for the oil price rise. The
Federal Reserve has cut the prime lending rate repeatedly since August 19, 2007,
in a valiant effort to improve the
financial situation of key lending organizations. The two
largest reductions occurred in January 2008. Almost every
reader will agree that the actions were essential. Even so,
they carried a very large cost: in the process of cutting rates,
the Federal Reserve appears, in the view of many, to have
given up its battle against inflation. This capitulation has
fueled the oil price rise. Traders and investors noted the
Fed’s surrender and rushed to invest in oil. At the same time,
those who own oil have concluded they are better off removing
the commodity from markets. The upward crude price
spiral is the result.
CONSEQUENCES
OF CAPITULATION
The Fed’s interest rate cuts have raised widespread concerns
regarding the return of stagflation or worse. In late February,
for example, CalPERS, the manager of the retirement fund
for employees of the State of California, announced it was
reducing the share of its portfolio allocated to fixed-income
securities while boosting the amount allocated to
commodities sixteen-fold to $7 billion. Other pension
fund managers acted similarly in late 2007,
while still others have announced their intention to
boost commodity investments in 2008.
Oil futures are one outlet for these funds. Under
the allocation models used by CalPERS and other
investors, half of the cash assigned to commodities
will be “invested” in crude. The flow of cash must,
absent a compensating increase in the supply of
futures, lift oil prices. In 2008, this flow of funds has
contributed to the oil price rise.
The price rise has been heightened by the
absence of a supply boost to match the increased
demand for futures from CalPERS and other
investors. In fact, producers have lost their appetite
for selling forward as prices have risen. A view made
popular thirty years ago—“oil in the ground is worth
more than money in the bank”—might well be making
a comeback.
CONFUSION IN PHYSICAL MARKETS
As oil prices have increased, many in the oil industry have
asserted that “fundamentals” are not to blame. Marathon
Oil’s CEO, Clarence Cazalot, for example, had this to say in
a talk given at the end of February: “Higher prices are not
simply the result of greater demand.” He pointed out that
Marathon was being offered plenty of oil and then concluded,
“If we bought and sold crude oil purely on principles
of supply and demand, there’s no question in my mind the
price would be lower than where it is today.”3
Cazalot went on to explain that part of the price rise
could be attributed to futures traders and the apparent “instability
in the world.” Cazalot’s remarks echoed those made
twenty-eight years ago by Walter Hoving, who was then
president of Tiffany & Co. At the time, Tiffany’s and other
major jewelry manufacturers were being buffeted by a tenfold
increase in silver prices even as more and more supply
was being created. Hoving and Tiffany’s were, of course,
the victims of the aggressive silver buying of the Hunt brothers
and other speculators.
In 2008 (as in 1980), physical commodity markets are
being roiled by traders and investors looking for protection against inflation.
Some of these traders are speculators or
hedge fund managers. Other investors, though, are pension
funds such as CalPERS. The buying done by these institutions
tends to raise prices.
Price increases could become especially large if the
entities that traditionally sell oil futures contracts back away
from the market. In such circumstances, continued efforts
by financial institutions to acquire claims on oil could cause
very large increases in oil prices, just as the aggressive buying
of silver futures contracts in late 1979 and early 1980
caused the tenfold increase in silver prices. As this article
went to press, the prospect of an oil price increase like the
one experienced by silver twenty-eight years ago appeared
very possible.
The risk of another large jump in oil prices comes from
the bilateral nature of futures markets and the oil market’s
uncompetitive structure. In commodity futures markets,
there must be a seller for every buyer. New buyers cannot
acquire claims on oil if new sellers are not willing to sell or
if those holding existing claims are not willing to relinquish
them.
In the oil market today, producers and traders seem
unwilling to initiate new short positions. The constraint
can be observed in open interest. Figure 3
traces open interest in the three principal crude oil
futures contracts from January 2000 through the end
of February 2008. Open interest peaked in November
2007 at 2.8 million contracts and has declined since.
At the beginning of March 2008, only 2.5 million
contracts were open.4
The consequence of increasing demand combined
with the diminishing supply of any commodity
is well known, and oil is no exception. Prices rise.
In this situation, the upward limit on oil futures prices
occurs when buyers step away from the market.
Conditions in the physical market for many
commodities would, however, break the upward
price movement. In the case of silver, for example,
the tenfold increase in prices brought forth a large
supply increase from mines and attics. In fact, one
of the real surprising discoveries in 1979 was the
large potential supply of silver that came from ordinary
individuals who saw a chance to cash in by selling
heirlooms. So great was the supply increase that
the cost of refining silver rose from seven cents per
ounce to five dollars per ounce in just six months.
The increase in the supply of silver did not, however,
break the upward movement in prices.
Speculators, especially the Hunts, kept buying. The
price increase was broken only by aggressive action
on the part of the Fed and the COMEX.
Oil will not benefit from such a supply increase.
Instead, oil-exporting countries seem content today to
produce enough to meet global demands at current
prices. Oil is sold FOB [or free on board, where the
buyer takes responsibility for shipping] on contracts
tied to the spot market. Thus, the receipts of oil
exporters will rise as prices are bid higher. As
Marathon’s Cazalot explains, more oil is available.
However, his company will not buy more at these
prices. Furthermore, tightening credit conditions have
no doubt forced some independent refiners to purchase
less. If refiners buy less, OPEC members willrespond by producing less.
Consumers cannot count
on help from the cartel.
THE LINK TO THE DOLLAR
With this background, it is fair to conclude that the
link between the falling dollar and rising oil prices
was created by the same force: the Federal Reserve’s
failure to control inflation expectations. The Fed’s
unilateral cuts in interest rates have caused investors
to move away from the dollar and acquire claims on
assets that offer protection against inflation. Thus it
is not surprising to see oil prices rise as the dollar
falls. What is surprising, however, is to find the dollar
moving in lockstep with oil prices as can be
observed in Figure 1.
The close linkage shown in Figure 1 is a recent
phenomenon. Over the last ten years the movements
in the dollar and the euro have tended to be in the
same direction, but not as closely tied. The looser
linkage can be observed in Figure 4. There, monthly
averages of the price of dated Brent are compared
with monthly averages for the dollar. One may
observe the dollar and the price of oil have generally moved
in the same direction but with significant deviations. More
deviations should be expected in the future.
LOOKING FORWARD
It is not possible to look at the recent oil price rise and the
dollar’s fall in value with equanimity. By the end of the
spring, the United States may be forced to end its “benign
neglect” of the dollar. In the past, the Federal Reserve and
Treasury have been expected to act in concert to address
such problems, with an increase in interest rates making a
major contribution.
In 2008, the precarious state of many financial institutions
may force the Fed to leave interest rates unchanged.
This does not imply, though, the Fed or other central banks
are powerless. Instead, they may need to look to alternative
measures. Given the disconnect between financial and physical
commodity markets noted above, one measure banks
could use would be moral suasion, which is what they did
during the silver crisis. In 1980 the Federal Reserve
instructed banks to apply special restraint to financing speculative
holdings of commodities or precious metals. Banks
got the message and cut off those speculating in silver. In
2008, the Fed and the European Central Bank could instruct
commercial lenders to use caution in lending to hedge funds
and other institutions to the extent that borrowers used the
funds to speculate in commodities. Such a step would break
the oil price rise and quite possibly the link between the dollar’s
exchange rate and oil prices. ◆
NOTES
1. Environmental agencies across the globe have demanded that
refiners remove almost all sulfur from diesel fuel. The benefits of
this action are visible daily in most major cities where one no
longer smells the diesel exhaust from buses and trucks. These benefits
come at a significant cost, however.
2. I have argued in testimony to the U.S. Congress that the U.S.
Department of Energy does not need to add sweet crude oil to the
Strategic Petroleum Reserve because such crudes are not required
in a crisis. Instead, DOE could add crudes with heavier sulfur content.
In the future, refiners will probably be able to use such crudes
to make ultra-low-sulfur diesel, especially if use were cut during the
crisis. However, environmental authorities could also ease environmental
regulations temporarily, thereby making the need for
low-sulfur crude unnecessary.
3. Katherine Fraser, “Marathon’s Cazalot Says Oil Price Spikes
Make No Sense,” Platts Global Alert, February 28, 2008.
4. The three major contracts are the NYMEX light sweet crude
contract, the IPE Brent crude contract, and the ICE light sweet
crude contract.