The Link Between Oil and the US Dollar

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What does the faltering oil price tell us about the strength of the global economy? The price of the international benchmark, Brent crude, has gone from US$115 a barrel in June to US$92 now. That’s a 20% decline in just over three months!

Does this tell you that the global economy has slowed sharply in recent months? Or is it more a US dollar strength story? That’s what I’m going to try and figure out in today’s Daily Reckoning.

First, take a look at the chart below. It shows the Brent crude price over the past two years. While the recent price decline has been dramatic, a far sharper decline occurred in early 2012. That was in response to the waning momentum of the ‘Arab Spring’, where Egypt and Libya were on the brink of revolution.

Back then, panic selling followed panic buying and the US dollar wasn’t really a factor in the price movement. It was really all about geopolitics.

Oil price falls point to weak demand

But now, there’s a lot more going on. The sharp drop in oil prices is symptomatic of some major movements of capital across the globe. It’s all about the end of the US Federal Reserve’s quantitative easing (QE) program.

The Fed has gone from pumping US$85 billion per month into global asset markets up until the end of 2013, to pretty much nothing now. That’s a lot of liquidity that has just disappeared. Formerly, this liquidity found its way into emerging markets (stocks, bonds and currencies) as well as anything with a decent yield like the Australian dollar and dividend paying blue chips listed on the ASX.

But now, the ‘drying up’ of this liquidity is having a major impact on asset markets around the world. The biggest impact you’re seeing so far is in the currency markets. The US dollar is again assuming its mantle as ‘King Dollar’. It’s the strongest currency in the world right now.

US dollar strength is most notable against emerging market currencies like the Turkish lira or the Brazilian real. The Aussie dollar hasn’t escaped either. In early September, currency traders decided the Aussie was simply a commodity currency…again. In that short timeframe, the greenback has surged around 8%. When it comes to currency markets, that’s a very big move.

A sharply rising US dollar usually signals a lack of global liquidity. For example, in the credit crisis of 2008, the dollar surged higher as stocks and commodities all tanked.

A similar scenario is unfolding this time around, although it’s nowhere near as acute. Still, for Aussie investors, it’s pretty painful. As well as the dollar falling, the local stock market is down, as previously created Fed liquidity evaporates into thin air.

Which brings me back to the oil price. You can put a large part of its decline down to the strength of the US dollar. Regardless of demand and supply dynamics, when the US dollar strengthens, anything priced in US dollars, like gold or oil or any other commodity, will fall.

What should worry the oil bulls though is that considerable geopolitical instability isn’t helping the price out. You have heightened tensions between Russia and the West…and Russia is one of the largest energy suppliers in the world. And you also have yet another war going on in the Middle East, the product of past wars in the Middle East designed to stop future wars in the Middle East.

That these geopolitical risk premiums are not providing any price support suggests the demand outlook for oil is weak and getting weaker.

You can put that down to China. There is little doubt that China’s economy is slowing. And as you’ve seen over the past few months, China’s rulers are no longer interested in resorting to large scale stimulus measures whenever growth disappoints. They did that in 2012 and 2013 and it only blew China’s credit bubble bigger.

Making matters worse for China, a strong US dollar is painful for their economy. They loosely peg their currency, the yuan, to the dollar. So a strengthening dollar hurts export competitiveness.

You’re not seeing any visible signs of this discomfort yet, but if US dollar strength persists, it could become a problem. It could also become a problem for other emerging market nations, especially those who have borrowed in US dollars but must repay interest and principle in their local currency. Borrowing in a strong currency and repaying in a weak one is rarely a good combination.

Moving closer to home, the biggest impact on Australia so far is via the iron ore price. Thanks to a slowing China and strong greenback, iron ore prices are now under US$80/tonne, down from around US$130/tonne at the beginning of the year. Given it’s Australia’s largest export and has underpinned our recent economic expansion, such a sharp price decline is a very big deal.

It impacts budget revenues at both the state and federal level, and it indirectly effects Aussie wages via its influence on ‘national income’.

I won’t go into that today. For now, it’s enough to point to the performance of the world’s largest iron ore miners, BHP and Rio, both down 2% this afternoon. Not to mention previously emerging, now submerging, iron ore player Fortescue, down 4%.

The Australian stock market can’t catch a break right now. A strong lead from Wall Street is no longer enough to push stocks higher. That’s because with the iron ore price collapse, foreign capital is getting out. For the Aussie economy, the flow on effects from this price collapse will be considerable.

Luckily, we have a strong property market that will help weather the coming storm, right?


More on this tomorrow…


Greg Canavan+
For The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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4 Comments on "The Link Between Oil and the US Dollar"

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slewie the pi-rat
slewie the pi-rat
2 years 18 days ago
as usual, a fine analysis. a short while back, i put up slewienomics’ analysis that some-to-much of the US equities’ strength should be attributed to a historically low “Discount Rate” [which rate is bottom-bumping due to the historically low “interest rates”]. a low-low Discount Rate values future dividend flows and the hocus-pucus focus of “earnings” more highly than a higher Discount Rate. so, a low D.R. generally means higher equity prices. i now see that Henry Bonner, in his recent interview of Jim Grant, has published the same [or similar?] “low D.R. = higher stock prices” reasoning, from his interviewee,… Read more »
2 years 18 days ago
Chinese grwoth will (from 2012 onwards) be adversly affected by rapid population aging and falling fertility and eventual population decline, but this along would not affect the oil demand too much as growing sections of the population desire a higher standard of living (at least to the American level). Oil demand will continue to grow in Asia even as birth rates continue to decline. The US will continue printing money and running up its debt but the world economy will allow this as the alternative is depression. Oil prices will not stay low for long. I have heard waffle about… Read more »
2 years 17 days ago

The world’s economies have already demonstrated that they can not afford expensive oil.
Peak oil mates, peak oil.
BTW: Modern agriculture is the process of turning fossil fuels into food. Get ready for very hard times.

2 years 17 days ago
Some Russian oil commentators are saying the broader global oil market is convinced that Libyan oil will come back to regular or even higher production levels by mid next year (I am curious in respect of this call and wonder whether fragmentation into statelets is the market’s expectation …). There is also the present supply growth incentive of the floating – fast depreciating ruble – where revenues are in USD and costs in the now very low ruble – incentive for fast higher profits and a handy national forex stabiliser if they were to be able to ship more. Politically… Read more »
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