Weak Dollar, High Oil Have U.S. Over A Barrel

So you scrapped your costly European vacation on account of the weak dollar. You did so to pay for your ever-increasing energy bills. Did you ever consider that the two might be related?

Conventional wisdom tells us that the trends of a falling greenback and soaring oil prices developed separately over time, driven by distinct economic and monetary factors. The rise in oil prices is a result of growing global demand, geopolitical tensions and supply constraints. In the case of the shrinking dollar, comparatively low interest rates, swelling budget and current account deficits are often to blame.

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The big picture, however, suggests otherwise.

“With the dollar falling against a basket of currencies, some of which are commodity driven, what is taking place is not just a negative correlation between the dollar and crude oil, but with commodity prices in general,” says Steven Ricchiuto, Fixed Income, FX and Commodities Strategist at Handelsbanken. And that is inherently inflationary.

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Others say the dollar’s devaluation is creating problems specific to the oil industry. Dr. A.F. Alhajji, an energy economist and professor, says a weak dollar limits supply by reducing drilling activities—especially in the North Sea where companies pay their costs in euros and sell their oil in dollars.

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On the demand side, a weak dollar makes oil less expensive because it is increasing the purchasing power of currencies that have been gaining in value against the dollar, offsetting some of the rise in prices and boosting consumption.

The result is a Catch-22 dynamic. “The lower dollar reduces supply and increases demand, thus raising oil prices,” explains Alhaji, who is an Associate Professor of Economics at the College of Business Administration, Ohio Northern University. “As a result, the value of US oil imports increases, which in turn widens the trade deficit, which weakens the dollar further.”

The dollar/oil correlation may also be magnified by market speculation and the tendency of markets to drive trends to extremes.

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When oil prices reached record highs on new Iranian sanctions and heightened military tensions on the Iraq/Turkey border, the dollar — which traditionally benefits from geopolitical crises as a safe-haven trade — collapsed to record lows against the Euro.

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There’s now some concern that the dollar/oil trade could reach such speculative proportions that its negative effects may be amplified beyond economic fundamentals.

There’s little chance the fundamentals will change anytime soon.

“As long as significant downward pressure on the dollar and supply constraints remain, the current negative correlation will continue,” says Ricchiuto. 

Given the US government’s currency stance — a vaguely defined strong dollar policy combined with a laissez-faire attitude — and the current low interest rate environment, chances for a major dollar reversal seem very slim.

© 2008 CNBC.com