When the Value of the Dollar Moves One Way, Oil Prices Move the Other

Even though most crude oil does not come from the United States, it is priced in American dollars on world markets. That seems like it should mean that the value of a dollar does not affect the price of oil. After all, as the value of the dollar goes up or down against the yen or euro, the price of most everyday items stays the same—your morning coffee and newspaper still cost the same, for example. However, in fact that’s not the case: oil prices increase and decrease with the value of the dollar.

When the value of the dollar goes down, the price of oil goes up. When the value of a dollar goes up, the price of oil goes down.

Why is that? To start with, the dollars that oil-producers earn in exchange for their oil are used to pay for other things. Maybe they are used to buy cars and electronics from Japan, construction equipment from Germany, or food from Africa. Dollars from the sale of oil are also used to pay salaries and wages in oil-producing countries. These things are often valued and paid for in currencies other than the dollar, be they yen, euros, or Saudi Arabian riyals.

To simplify things, let’s lump all other currencies together into IMUs, or “international monetary units.” Let’s say that a dollar is worth 1 IMU. That means that if oil sells for $50 a barrel, the oil-seller can use those dollars to buy 50 IMUs worth of goods from other nations, or pay 50 IMUs worth of salaries.

What happens when the value of the dollar declines against the IMU, so that a dollar is only worth 0.8 IMU, or it takes $5 to equal 4 IMUs? When that happens, $50 is only worth 40 IMUs. The oil-producer has lost 20% of its buying power. In order to make up for that, it needs to increase the price of a barrel of oil to $62.50. That way, when dollars are only worth 0.8 IMUs, it still receives 50 IMUs worth of purchasing power by selling a barrel of oil, since $62.50 x 0.8 = 50 IMUs.

The opposite happens when the value of a dollar increases against the IMU. When a dollar is worth 1.25 IMUs, $4 buys you 5 IMUs of purchasing power and it only takes $40 to equal 50 IMUs. The price of crude oil on the international market, which affects the price you pay for heating oil, decreases.

Also, people other than Americans buy oil, and they use their own currency. For example, China has become a major consumer and importer of oil—in 2007, it was estimated that China consumed 7.88 million barrels of oil a day, and imported 4.21 million. While that is much less than the United State’s estimated consumption of 20.68 million barrels per day, to put the size of Chinese consumption into perspective, India has 87% of China’s population but consumes only 35% as much crude oil (2.72 million barrels per day). China also consumes much more than heavily industrialized Germany (2.46 million barrels) or Japan (5 million barrels).

On March 29th, 2009, it took about 6.8 Chinese yuan to equal 1 dollar. A year ago, however, it took around 7 yuan to equal 1 dollar. That means there’s been a 3% decline in the value of the dollar versus the yuan.  A Chinese investor who could have bought 100 barrels of crude a year ago could—assuming the price of oil in dollars was the same—buy 103 barrels today. That in turn means that to buy 100 barrels using U.S. dollars, an American investor would have to offer 3% more dollars just to match the Chinese investor’s offer.

The value of a currency fluctuates daily. For example, the chart below shows how the value of a dollar has changed over a recent one-month period against the value of what is probably the single most important other currency: the euro.

The value of the US dollar vs. the Euro, February 1, 2009-March 27, 2009 (image: x-rates.com)

Over the last month, two things have occurred:

1)    The overall value of a dollar compared to a euro has decreased: on February 23rd, for example, it took around 1.27 dollars to equal 1 euro, but on March 27th, it took 1.33. The decline in value of the dollar occurred at the same time the price of crude oil increased from late February 2009 to late March.

2)    However, in the last week, dollars gained back some ground against the euro, and this increase in the strength of the dollar has helped drive down the price of crude oil.

In real life, it’s more complicated than that. The dollar is not measured against one currency, our made-up IMUs, but against many. Also, there are many more factors affecting oil prices as well, including supply, demand, political events in oil-producing countries, and the action of the financial and commodities markets. However, the general principal still holds: a strong dollar makes it less expensive to buy oil; a weak dollar makes it more expensive.