Monday, January 4, 2010

Forget Gold, America is on the Crude Standard

Almost every single day in 2009, the Wall Street Journal commodities report said something to the effect of:
"Oil prices moved [up/down] on reports of global reserves potentially [shrinking/growing]. Also contributing to oil's movement was expectation of the dollar's [weakening/strengthening]."
Now, perhaps because I still like to read my paper on paper, I have the luxury of witnessing an illuminating if unintentional juxtaposition; the WSJ's currency report, about four days a week, appears on the same page as the commodity report - often immediately adjacent. And almost every single day, each section runs some sort of chart showing (respectively) oil prices, and the US Dollar's value over some period of time. Let's cut to the chase...
Here's oil prices (continuous front-month oil futures on the NYMEX) for all of 2009:
And here's my proxy for dollar strength, the Dollar to Swiss Franc* conversion rate over 2009:
Notice anything interesting? The prices are moving in almost perfect inverse synchronicity. That is to say, when the dollar is strong, oil gets cheap, and vice versa. Now naturally, that is to be somewhat expected; the law of supply and demand assumes the resultant "price" is reported in a single currency, but in the real world it doesn't work like that. If supply and demand do not change, the value of the good can be expected to change in relation to the value of the currency in which that good is priced. In this way, a correlation between oil prices and the value of the dollar makes sense. However the sort of extreme correlation seen here over the past year is pretty ridiculous. (For comparison, go check out the oil and USD/CHF charts on, say, a five or ten year horizon, the correlation all but disappears.)
Now where this observation gets interesting is in determining which variable is dependent on which. The obvious interpretation is that the value of the dollar is driving oil prices. That said, another way to look at this, one that is more interesting and perhaps more fiscally frightening (assuming you're American) is to flip the causation and hypothesize that the value of the dollar itself is being driven by the price of oil.
Consider, the United States of America runs on oil. No single thing (I'd use the word "factor" but it didn't seem broad enough) affects the overall state of the American economy as does the price of oil. Every facet of our commerce, from personal transportation, to air travel, shipping, manufacturing, even the generation of electricity, all of it relies on Texas Tea. Now, assume for a moment that as other economies begin to emerge, creating their own demand for oil and thus disrupting what was previously a largely two-way trade channel (dollars go to the middle east, oil comes to the land of the free), the value of oil as a commodity begins to have an effect on the very means by which it is purchased.
Take an extreme example: suppose Saudi Arabia, impressed with the continued strength of the Indian Rupee and betting that strength will continue, agrees to sell oil to India (that is, directly and not through an American exchange) at a price of Rs 2500/Barrel (2500 Rupees per Barrel). This would fundamentally set the Dollar/Rupee exchange rate, as 2500 Rupees is now the true value of a barrel of oil, whatever it may cost on the NYMEX. (For those of you keeping score, if oil were $75 a barrel, this would mean the USD/INR exchange rate would fall to Rs 33.33 per dollar. As of this writing, that's about a 28% decrease from today's exchange rate of Rs ~46.25 per dollar.)
I called the above example extreme for a reason; it is. More likely than not, in today's economy such a sale would have a more immediate effect on the commodity markets than the currency, but the point is valid. As nations other than the United States become more involved in the global oil trade, the repercussions of such trade can only have a more profound effect on the value of the currency in which oil is priced. And that would be the dollar. Since the dollar's value is unfixed, the more oil becomes the basis of world commerce, the more the dollar's value relies on how much oil it can purchase.
I wouldn't be at all surprised, one day soon, to hear a loud, southern congressmen proclaim to a captivated populace that we "shall not crucify mankind upon a cross of oil."
I don't know, maybe the metaphor doesn't work as well with a liquid.
*I chose Swiss Francs because of the currency's relative stability. If I had chosen another currency, say, British Pounds, that country's own financial turmoil would have had a more dramatic effect on the quote given and would have been less reliable as a proxy for the Dollar's value. In other words, the Swiss Franc, in my mind, is the best benchmark for a currency's true value, as the geopolitical fallout of some other country is relatively minimized by the Swissie's historic stability.

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