The international oil price and the US dollar: Are they related?

The international oil price and the US dollar: Are they related?

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Yesterday I read an article that really caught my attention (, in this article Mr. Paul R. La Monica comments on the recent increase in international oil prices. Mr. La Monica hypothesis is that the Federal Reserve of USA would aggravate such price escalation, announcing that a buying of long-term bonds from the Treasury for US$ 600 billion, this would lead to depreciate the dollar and push for increases in prices of some commodities

The logic behind the hypothesis of Mr. La Monica is very entertaining and I will try to explain it as follows. Imagine that you regularly sells 1,000 barrels of oil per month at a price of, say, US$ 50/barrel, thus you will receive a gross income of US$ 50,000. You, because don’t trust in US dollar, decide to convert your monthly wealth to euros, then, if we assume that the market pays one euro per dollar, your will get € 50,000, you can now sleep peacefully, because your wealth is the currency that you consider a «strong» one. After a few months, the person in charge of the amount of dollars in the economy announces that he will «release» more dollars into the market, then, like in any other market an increase in supply tends to reduce prices, you can anticipate that more dollars will reduce «the price of US dollars «, thus with high probability, the future change could well be 1 euro for every 2 dollars!

Naturally you are now in panic, because, for the sale of its 1,000 barrels of oil, you will receive US$ 50,000 but with the new exchange of rate you’ll have € 25,000, your wealth will fall by half. What to do? How to have again those juicy € 50,000 per month? An alternative, and is the centerpiece of the Mr. La Monica hypothesis, would be to increase the oil price in US dollars. The math is simple, instead of selling each barrel in $ 50 you sell at $ 100, thus for the sale of 1,000 barrels per month you will have US$ 100,000 that with the new exchange of rate of 2 dollars per 1 euro, you will get € 50,000.

After reading Mr. La Monica article, I was thinking of the hypothesis and decided to turn to statistics. Basically what I did is contrast an international oil prices (WTI) with the exchange rate US$/€ in the future. If Mr. La Monica hypothesis is correct, an anticipated rise in the exchange rate US$/€ (more dollars for 1 euro) should be positively correlated with an increase in the oil international price.

After performing a statistical exercise (basically look simple correlations) I chose to plot the price of oil against the exchange rate of the 8 month future. For example, I correlated the WTI January 2009 against the exchange rate US$/€ in September of the same year. The results of this exercise are in the following figure.

Frankly the correlation between the two variables is higher than I expected, of course, is not perfect, however, I have a sneaking suspicion that a thorough and well done econometric analysis (hopefully someone is encouraged to do so) can confirm that the exchange rate (US$/€) could well explain some part of the international oil price behavior.

In this sense, the announcement of the Federal Reserve to inject more dollars into the economy, could reinforce the strong growth in international oil prices saw in recent weeks. Only the path of events will give (or not) the reason to the suggestive hypothesis of Mr. La Monica, for the moment I will diversify my assets portfolio decreasing the green color of it.

Mauricio Medinaceli Monroy

La Paz, December 2010

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