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  1. Home
  2. / Investing
  3. / Energy

Why Oil Prices Affect Exchange Rates, not Vice-Versa

Central banks can no more set the price of oil than the Saudis can set U.S. interest rates.
By MIKE NORMAN May 27, 2015 | 03:00 PM EDT

Many people believe that the price of oil is dictated by the foreign exchange value of the U.S. dollar, and in the past they've blamed the Federal reserve's policies for hurting the dollar and, by corollary, driving up the price of oil. We've already seen how the Fed's policies have not had a negative effect on the dollar. The Fed's balance sheet is more than five times the size it was back in 2008, and the dollar is substantially higher.

The entire meme that the Fed is "debasing" the dollar holds no water whatsoever so, I hope that people can start putting it away. I know there will always be folks who will believe the "money printing, debasing the currency" story, but they're the same people who subscribe to alien abductions and finding Bigfoot (the latter holds more promise than the Fed debasement claim).

Now let's get back to oil prices.

What if rather than the foreign exchange value of the dollar driving the price of oil it were the opposite? What if the price of oil dictated the foreign exchange value of the dollar?

By now you should understand that there are monopolistic forces in the oil market. Whether we are talking about OPEC, the Saudis or the newfound pricing power of North American shale oil producers, there is a price-setter.

The foreign exchange value of a currency may fluctuate, but it does not change the supply and demand fundamentals of oil. If my currency is the dollar and the dollar's exchange rate falls against the yen, then my consumption power is reduced in exact proportion to the gain of the person who is based in yen. All that happened was that demand was re-distributed. There was neither more or less demand nor more or less oil.

On the other hand, when the Saudis set the oil price lower (in dollars), then it means the dollar buys more oil. Another way to say that is that the dollar's foreign exchange value goes up in real terms and forex markets adjust to that new reality. On the flip side, let's say the Saudis raise the price in dollar terms. That means the dollar buys less oil and that equates to a de-facto reduction in the dollar's foreign exchange value. Once again, the forex markets make that adjustment in real-time trading.

This is how it works in real life. Central banks can no more set the price of oil than the Saudis can set what U.S. interest rates will be. It's just that simple. On the other hand, oil prices that are set by monopolists affect the exchange rate of currencies and since oil is priced in dollars, each adjustment to the price by the monopolist is a de-facto adjustment in the foreign exchange value of the dollar.

If you understand this, it should help in your trading and investing -- although I would caution on one thing: If market participants believe it to be the other way around, then you will see that effect manifest in oil prices for a while, at least until portfolio shifts run their course. Then it will go the other way as the causation runs from oil prices to exchange rates, not vice-versa.

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TAGS: Energy | Investing

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