Understanding the Correlation of Oil and Currency

There is a hidden string that ties currencies to crude oil. With the price actions in one venue, it forces a sympathetic or opposing reaction in the other. This correlation persists for many reasons, including resource distribution, the balance of trade (BOT), and market psychology. Also, there is crude oil’s significant contribution to inflationary and deflationary pressures that intensifies these interrelationships during strongly trending periods—both to the upside and to the downside.

Oil and the U.S. Dollar

Crude oil is quoted in U.S. dollars (USD). So, each uptick and downtick in the dollar or in the price of the commodity generates an immediate realignment between the greenback and numerous forex crosses. These movements are less correlated in nations without significant crude oil reserves, like Japan, and more correlated in nations that have significant reserves like Canada, Russia, and Brazil.

Key Takeaways

  • Oil and currencies are inherently related wherein price actions in one force a positive or negative reaction in the other in countries with significant reserves.
  • The USD has benefited from crude oil’s precipitous decline since the energy sector is a significant contributor to U.S. GDP.
  • Countries that depend heavily on crude exports experience more economic damage than those with more diverse resources.
  • Countries that buy crude oil and those that produce it exchange USD in a system called the petrodollar system.

Development of Oil Correlations 

Many nations leveraged their crude oil reserves during the energy market’s historic rise between the mid-1990s and mid-2000s, borrowing heavily to build infrastructure, expand military operations, and initiate social programs. Those bills came due after the 2008 economic collapse, where some countries deleveraged while others doubled down, borrowing more heavily against reserves to restore trust and trajectory to their wounded economies. 

These heavier debt loads helped keep growth rates high until global crude oil prices collapsed in 2014, dumping commodity-sensitive nations into recessionary environments. Canada, Russia, Brazil, and other energy-rich countries struggled for a few years, adjusting to plummeting values in Canadian dollars (CAD), Russian rubles (RUB), and Brazilian reals (BRL), but showed signs of rebounding in 2016 and 2017.

Selling pressure has spread into other commodity groups, raising significant fears of worldwide deflation. This has tightened the correlation between affected commodities, including crude oil and economic centers without significant commodity reserves like the Eurozone. Currencies in nations with significant mining reserves but sparse energy reserves, like the Australian dollar (AUD), have plummeted along with the currencies of oil-rich nations.

Trouble in the Eurozone

Plummeting crude oil prices set off a deflationary scare in the Eurozone after local consumer price indices turned negative at the end of 2014. Pressure built on the European Central Bank (ECB) in early 2015 to introduce a large-scale monetary stimulus program to stop the deflationary spiral and add inflation into the system. The first round of bond-buying in this European version of quantitative easing (QE) began the first week of March 2015. QE by the ECB continued until mid-2018. 

EUR/USD vs. Crude Oil

Image by Sabrina Jiang © Investopedia 2020

Many forex participants focus their full attention on the EUR/USD cross, the most popular and liquid currency market in the world. The currency pair topped out in March 2014, just three months before crude oil entered a mild decline that accelerated to the downside in the fourth quarter—at the same time crude broke down from the upper 80s to low 50s.  Euro selling pressure continued into March 2015, ending at the same time that the ECB initiated its monetary stimulus program.

Venezuela has the largest number of crude oil reserves, according to OPEC.

U.S. Dollar (USD) Impact

While the United States has moved up the ranks in worldwide petroleum production, the U.S. dollar has benefited from crude oil’s precipitous decline for several reasons. First, U.S. economic growth since the bear market has been unusually strong compared to its trading partners, keeping balance sheets intact. Second, while the energy sector significantly contributes to U.S. GDP, America's great economic diversity reduces its reliance on that single industry.

USD vs. Crude Oil

Image by Sabrina Jiang © Investopedia 2020

Invesco DB U.S. Dollar Index Bullish Fund (UUP), a popular USD trading proxy, hit a multi-decade low at the height of the last bull market cycle in 2007 and turned sharply higher, hitting a three-year high when the bear market ended in 2009. Then, higher lows in 2011 and 2014 set the stage for a powerful 2014 uptrend that began just one month after crude oil peaked and entered its historic downtrend.

Inverse lockstep behavior continued between instruments into 2015, when the USD continued its pullback. The top was simultaneous with the start of the ECB's QE program, illustrating how monetary policy can overcome crude oil correlation, at least for significant time periods. The run-up into an anticipated FOMC rate hike cycle has contributed to this holding pattern as well.

Results of Over-Dependence

It makes sense that nations that are more dependent on crude oil exports have incurred greater economic damage than those with more diverse resources. Russia offers a perfect example, with energy representing over 65% of its total 2014 exports.

The country fell into a steep recession in 2015, with GDP declining 4.6% year-over-year in the second quarter of 2015, intensified by Western sanctions tied to its Ukraine incursion. GDP for Q3 2015 fell 2.6% year-over-year, and then 2.7% for Q4 2015. Then, with the turnaround in crude oil prices, Russian GDP saw a marked turnaround. GPD growth turned positive in Q4 2016 and has remained so ever since.

Gazprom is Russia's largest oil producing company.

Here are the countries with the highest crude oil exports based on barrels per day, according to the CIA's World Factbook with data from 2014:

  • Saudi Arabia with 7.3 million
  • Russia with 5.1 million
  • Iraq with 3.3 million
  • The United Arab Emirates with 2.7 million
  • Canada with 2.7 million

Economic diversity shows a greater impact on underlying currencies than absolute export numbers. Colombia ranks 19th, but crude oil represents 25% of total exports, pointing to high dependence illustrated in the collapse of the Colombia peso (COP) since the middle of 2014. Meanwhile, that country’s economy has cooled off considerably after a torrid growth spurt. 

The Ruble's Collapse

Many Western forex platforms halted ruble trading in early 2015 due to liquidity issues and capital controls, encouraging traders to use the Norwegian krone (NOK) as a proxy market. USD/NOK shows a broad basing pattern between 2010 and 2014 at the same time that crude oil was bouncing between $75 and $115.  Crude oil’s downturn in the second quarter of 2014 matches a powerful uptrend that accelerated in the fourth quarter. 

That rally continued into second-half 2015, with the currency pair hitting a new decade high. This points to continued stress on the Russian economy, even though crude oil has come off its deep lows. Still, the pair has soared along with crude oil. High volatility makes this a difficult market for long-term forex positions, but short-term traders can book excellent profits in this strongly-trending market.

The Bottom Line

Crude oil shows a tight correlation with many currency pairs for three reasons. First, the contract is quoted in U.S. dollars so pricing changes have an immediate impact on related crosses. Second, high dependence on crude oil exports levers national economies to uptrends and downtrends in the energy markets. And third, collapsing crude oil prices will trigger sympathetic declines in industrial commodities, raising the threat of worldwide deflation, forcing currency pairs to reprice relationships. 

Article Sources

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