RBN has documented many fundamental influences on crude oil prices including supply, demand and inventory levels as well as infrastructure constraints. One that we don’t often mention is the strength or weakness of the U.S. dollar. As with most international commodities - oil is bought and sold priced in U.S. dollars. As a result, a change in the value of the dollar relative to other currencies has an impact on oil prices. Likewise the dramatic fall in oil prices since June of 2014 has been mirrored by the dollar rising to levels not seen since 2003. Today we look at how oil prices are impacted by the value of the dollar.
Since the 1980’s crude prices have generally been determined through bilateral negotiation between counterparties based on differences in quality and location as well as other market fundamentals. Counterparties in these transactions typically make reference to widely traded benchmark crudes to link their deals to spot market prices (see The Cost of Crude At Cushing and Crazy Little Crude Called Brent). We recently described the formula pricing system used by Saudi national oil company Aramco to determine the price buyers pay for their crude – based on a benchmark linked to destination and a monthly adjustment factor (see The Price You Pay). All of these transactions are carried out using a single currency – the U.S. dollar. The reason why oil transactions take place in dollars dates back to the early dominance of the U.S. oil industry – that was originally the center of world production and the largest exporter in the 1930’s. Since World War II the dollar has been the dominant reserve currency and most international commodity transactions are carried out in dollars for the convenience and security of both parties.
Of course, the fact that oil is priced in dollars provides U.S. companies an inherent advantage over their competitors in other countries. For one thing, buyers and sellers here do not have to pay currency exchange fees to buy or sell the dollars they use in crude trades. In addition to those fees they also avoid any currency risk associated with refining outside the U.S. For example, overseas refiners have to buy their crude using dollars and sell their refined products to consumers in the local currency – so that exchange rate fluctuations can end up costing them money if they do not hedge that risk.
One side effect of oil being priced in dollars is that large investors often take financial positions in oil (usually in paper form e.g. in the futures market) as a hedge against a decline in the value of the dollar. The theory behind these hedges is that if the dollar loses value against other currencies then the price of oil will increase to compensate for that weakness – protecting the investor from dollar deflation. Obviously that works the other way around as well – with a stronger dollar tending to push prices down. With oil being such a huge commodity these financial players have an influence on the physical crude market because of the strong links between oil futures markets and physical prices (see The Cost of Crude at Cushing).
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