If I told you that the dollar would depreciate by 10% over the course of 2019, what would you expect crude oil prices to do this year? Most of you, I suspect, would guess crude would rally because:
- Oil is largely priced in dollars even though it is a global commodity.
- A lower dollar would therefore make oil more affordable in non-US dollar economies and encourage consumption/demand.
- Therefore, everything else equal oil prices would rise as the dollar declines. The same logic holds for gold, by the way, which is also priced in dollars around the world.
This heuristic may be common enough on Wall Street, but a post yesterday by the New York Fed’s economics team titled “The Perplexing Co-Movement of the Dollar and Oil Prices” shows it hasn’t quite made its way to 33 Liberty Street. Here’s what they had to say:
- “The pattern of the dollar weakening when oil prices move higher starts around 2005.” Looking at just the dollar/euro cross, Fed researchers found “the correlation was particularly noticeable in the 2006-2010 and 2014-2018 timeframes”.
- As for the exact relationship, “a 10 percent increase in oil prices is associated with a 1.5 percent depreciation of the dollar against the euro”.
- The Fed found that quarterly price changes in the dollar/euro cross and oil prices yielded the best statistical fit, and that there was no correlation present in the 1980s and 1990s.
Even with the seemingly obvious cause-and-effect relationship of oil prices/dollar level, the last comment intrigued us; what does the long-term record show on this count? You know our methods: we pulled the trade weighted dollar data from the St. Louis FRED database and oil prices from the World Bank and went to work.
Here’s the analysis and what the data shows:
- We used monthly oil and trade weighted dollar prices, running monthly changes and then did a rolling 12-month correlation of these 2 variables.
- Looking at the entire 1974 – present time series, the average correlation of oil prices to the trade weighted dollar index is -0.185. That equates to an r-squared of just 3% – not a great fit, in other words. The negative sign makes sense, at least, so we’re on the right track here.
- Break down the data into decades, however, and a clear trend emerges.
- From 1974 (first data available is 1973) to 1979, the oil/dollar price change correlation is just -0.01.
- It then grew modestly to -0.04 from 1980 – 1989.
- The oil/dollar price change correlation then grew to -0.27 from 1990 – 1999 and declined only modestly to -0.20 from 2000 – 2009.
- For the nine years from 2010 – 2018, the oil/dollar price change correlation has been -0.35. Yes, that’s only an r-squared of 12%, but the Fed’s work on just dollar/euro vs. oil prices shows an r-squared of 33%. So again, we’re on the right track.
The bottom line here is that oil prices are clearly becoming more tied to the dollar as non-US economies constitute more of global oil demand. That is something our simple explanation at the top of this note would predict. And the data shows the relationship is actually working that way.
Now, here’s what all this means for capital markets:
- A weaker dollar should be a tailwind for oil prices, and the long-run relationship here is only getting tighter.
- Don’t look for a day-to-day/tick-for-tick tie between the dollar and crude, however. The Fed data shows quarterly moves correlate the best, and Q4’s slow grind lower for the dollar (peak for 2018 in November) did little to arrest crude’s decline (troughed much later, on Christmas Eve 2018).
- The 5-year charts of oil and US Energy stocks look very similar, showing that the equities closely track the commodity (little surprise, that…).
- The bottom line here is that an overweight Energy stock position is increasingly a weak dollar bet. Yes, there are supply-demand and individual company fundamentals to consider as well. But the data we’ve presented here is clear: a weaker dollar really helps oil prices and, by extension, Energy equities.
So if you are tempted to overweight the much-beaten down Energy sector in 2019, remember that this is essentially a turbocharged weak dollar play. Not only do these companies have greater international exposure than the index (42% offshore revenues vs. 38%), but the crude is levered to the dollar as well.