The Correlation Between Oil and the Dollar (and how it is changing)

Crude oil shows a strong correlation with many currency pairs in Forex markets. This evidence is confirmed by many empirical studies and supply a great help to forex traders. The main reason for this correlation is that oil contracts are denominated in U.S. dollars. Therefore, a change in oil prices has an immediate effect on the greenback. Furthermore, a change in oil prices affects industrial commodities, modfying countries’ inflation rates and forcing currency pairs to reprice. Finally, many countries are strongly dependent on oil and other commodities exports, so that a change in prices naturally affects their currencies. Countries that depend heavily on crude exports suffer more economic damages than those with more diversified economies, in case of oil shock. Countries that buy crude oil and those that produce it exchange dollars in a system called the petrodollar system.

Oil prices change affects the U.S. dollar, since the energy sector is a significant contributor to U.S. GDP. Since crude oil is quoted in dollars, ups and downs in the greenback or in the price of the commodity generates an immediate realignment among forex crosses. These movements are less correlated in countries without significant crude oil reserves, like France, and more correlated in nations that have them, like Canada, Russia, and Brazil. Currencies in nations with significant mining reserves but sparse energy reserves, like the Australian dollar, have plummeted along with the currencies of oil-rich nations.

Nations more dependent on crude oil exports incurres greater economic damage than those with more diverse resources. Russia is a perfect example, with energy representing 58.6% of its total 2014 exports. The country fell into a steep recession in 2015, with GDP declining -4.6% on a yearly basis in the second quarter of 2015, intensified by Western sanctions tied to its Ukraine incursion. GDP for the third quarter fell -2.6%, and then -2.7% for the fourth. Then, with the turnaround in crude oil prices, it experienced a marked turnaround, turning positive in the fourth quarter 2016 and has remained so ever since.

The correlation between crude oil and the dollar is declining nowadays, thanks to the U.S. shale-oil revolution. According to the EIA, the United States is now about 90% self-sufficient in terms of total energy consumption. Oil exports have increased and imports have decreased, meaning that higher oil prices no longer contribute to increase U.S. trade deficit, and actually helps to decrease it. As a result, we observe the historically strong inverse relationship between oil prices and the U.S. dollar is becoming weaker. Over the past eight years, the rolling 6-month correlation coefficient was mostly negative but considering the new scenario of the global energy market this negative correlation could soon turn positive.

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