Dollar Strength Is Likely To Cap Oil Price Gains

This morning, my old stomping ground of forex is making a rare appearance in the news. The problems in Turkey and the actions of the Erdogan regime caused the dollar index to spike overnight, which in turn drew attention to dollar strength that has been building for some time. Very few have been talking about it to this point, but the fact that the U.S. currency is at levels not seen for over a year is now becoming a subject of interest. That is probably overdue, but does it really mean anything for energy investors, or more specifically for the price of oil?

“The strength of the dollar influences the price of oil” is a sentence that to my mind should be an obvious statement of fact, yet a lot of people doubt it these days. The doubters, however get it wrong on two fronts.

First, they tend to misinterpret the statement above. I do not maintain that dollar strength is the only influence on the price of oil, nor even that it is the biggest, simply that it is one. Pointing to the lack of inverse correlation between the charts below, as those doubters often do, is therefore irrelevant. At different times, different things become the major influence on oil. It could be growth projections and their potential effect on demand, or OPEC squabbles and their potential effect on supply, for example. In reality of course, all those factors, and a whole host of others, are always simultaneously affecting price. When I say that “The strength of the dollar influences the price of oil” I am simply saying that it is one of those factors.

That is why there is no immediately discernible inverse correlation between oil and the dollar, as shown by the charts below. Dollar strength is just one of many influences on the price of oil, but that doesn’t mean that it should be ignored. At the very least, a strengthening dollar will limit the scope of a move to the upside, and if it becomes a focus of the market it will drive moves itself.

(Click to enlarge)

(Click to enlarge)

Second, the doubters have an overly simplistic and flawed understanding of the nature of the value of a currency. They will argue that because most of the crude produced in the U.S. is consumed here, the strength of the dollar is not a factor on the price of oil. If the product is being paid for by entities that have the dollar as their base currency, the argument goes, forex has no impact on price.

Ignoring for a moment the fact that U.S. crude is now being exported at an increasing rate, that is still a flawed analysis on multiple fronts. It assumes that only the value of the currency relative to others is important. It ignores the concept of intrinsic value: the idea that the Dollar’s relative strength should be measured not just against other currencies, but against the goods that it can be exchanged for. If the dollar is rising against other currencies it is also becoming stronger in a general sense. That stronger dollar doesn’t just buy more Euros or Yen than before though, it also buys more oil, in effect pushing the price of crude lower.

These things are always important to understand, but especially now, as dollar strength is likely to be a topic of interest for a while. The Fed is still ahead of other Central Banks in terms of rate hikes and tighter policy, while tax cuts and deregulation have given a boost to the American economy, both fundamental reasons why the dollar looks likely to continue higher.

As I said above, that alone doesn’t mean that WTI is headed lower. What it does mean, however, is that the topside is limited, and that there is always a negative influence on oil prices in the background. That is enough to tilt me towards a bearish bias for now.