If you are a forex trader, then oil price fluctuations concern you. Historically, oil prices and forex rates share an intimate relationship. This correlation exists due to many factors, such as balance of trade, supply chain patterns and market psychology.
Crude oil is an important source of energy, and fluctuations in its price affect the global economy. The currency exchange rate becomes one of the important channels through which international oil price shocks are passed on to the financial markets and the real economy. This is particularly true for major oil importing and exporting nations. Many of the world’s major forex pairs depreciate or appreciate based on oil price fluctuations.
The basic premise is that all oil exporting nations could see an increase in wealth transfer when price rises, as a result of increased export income. This increase reflects positively on the current account balance, in terms of the domestic currency. As a result, there could be an appreciation in the currency value. Similarly, the countries that import oil in large quantities can be benefitted with a decline in oil prices. This is the theory of the wealth effect channel.
On the other hand, economists say that when oil price increases, countries that have a large dependence on oil in the tradable sector are negatively impacted. Their currencies depreciate due to higher inflation. If the non-tradable sector of a country is more energy dependent, compared to the tradable one, the price output of this sector is greater than the other, in case of rising oil prices. This is the theory of trade channel.
The third theory is the portfolio reallocation channel. Crude oil is mostly priced in US Dollars. Both Brent and Crude, the two major oil price benchmarks are traded in US Dollars. Therefore, the dependence of the US on oil imports, relative to its share of oil exports to other countries, determines the short to medium term effect on forex rates. Oil exporters’ preferences for US Dollar denominated assets also influences exchange rates.
The US Dollar is the currency for invoicing and settlement in the international oil market. When the US Dollar rises, you need less of it to buy barrels of oil. Similarly, when it is weaker, it takes more US Dollars to buy oil. So, the two share an inverse relationship. Oil price hikes lead to depreciation in USD, and vice versa.
Historically, the US has been the largest net oil importer in the world. Rising price is a significant cause of rising US trade deficit. But since 2010, the United States has increased its domestic oil production successfully with horizontal drilling and fracking technologies. In fact, at 80,622,000 oil barrels per day, it is the largest oil producer in the world as of March 2019. US oil exports have increased relative to oil imports. So, rising price is no longer a significant cause of the nation’s trade deficit. Also, the negative correlation between the US Dollar and crude oil price is fast waning.
Apart from the United States, other major economies, like Canada and Russia, are dependent on the oil export-import balance. Given that oil trades form a major portion of their countries’ GDP, their currencies are significantly impacted by oil price fluctuations. These are sometimes called “petrocurrencies.”
As of March 2019, Canada is the 7th largest oil producer in the world. It has a significant energy trading relationship with the United States, and is, in fact, the country’s largest oil supplier. Over 16% of US oil imports come from Canada. This shows how exposed the forex pair is to oil prices. In August 2015, the pair declined to an 11-year low due to a global decline in oil prices.
Norway’s petroleum sector is an important part of its economy. It is not only a source of export revenue but also a source of finance for the Norwegian welfare state. In 2014-15, when prices reduced dramatically, NOK depreciated against the USD by 23%. From 2016 to 2018, NOK gained 13% against the USD, when prices started climbing.
Russia is the third largest oil producer in the world, with a production rate of 10,800,000 barrels per day. Oil exports constitute almost 50% of its export revenue. The country’s heavy reliance on oil and petroleum exports has been a reason for its economic decline in the past. On June 19, 2014, the Russian Ruble fell about 49.05% against the USD, when the Brent Crude price fell 49%.
The Brazilian Real and the Columbian Peso are other examples of petrocurrencies.
Fluctuations in forex rates don’t change the supply and demand fundamentals of oil. If the US Dollar falls against the Japanese Yen, then the US citizen’s consumption power is reduced in the same proportion to the gain of a Japanese citizen. Demand gets reallocated, but not changed.
There are somewhat monopolistic forces in the oil market. OPEC acts as a price setter, as do Saudi Arabia and US shale oil producers. When oil price is set lower in US Dollars, it means that $1 buys more oil. The Dollar’s forex value increases in real exchange rate terms. The forex market adjusts itself to the new changes.
This means that while oil prices set by monopolistic agencies affect forex rates, the reverse is not true.
Traders should keep note that currency exchange rates are impacted by many other factors like political tensions, monetary policies and natural disasters. There are other issues and events that impact the oil markets as well. Many studies that aim to show the correlation between the two markets do not rein in the supply-demand aspect as well.
All in all, it is evident that oil price shocks result in exchange rate pressure for exporter nations. These countries counter such pressure by increasing or decreasing foreign reserves holdings.