How Oil and Forex Are Correlated?

The Persistent Correlation of Oil and Currencies

There is a mysterious and compelling relationship that exists between the worlds of currencies and crude oil. It's a delicate dance of price actions wherein a move in one sphere can incite a corresponding or contrasting reaction in the other. This persistent correlation arises from various influencing factors, including the allocation of resources, the balance of trade—otherwise known as the equilibrium between a nation's exports and imports—and the often capricious nature of market psychology.

Furthermore, there's the undeniable influence of crude oil on inflationary and deflationary pressures. This effect has a way of amplifying the interconnections between oil and currency markets during strongly trending periods, whether they're climbing or descending.

Key Insights

• The price reactions in oil markets can cause a domino effect in currency markets, particularly in countries rich in oil reserves.
• A system known as the petrodollar system oversees the exchange of USD between countries that purchase and produce crude oil.
• The fall in crude oil prices has proven beneficial to the USD, given the energy sector's significant contribution to U.S. GDP.
• The U.S., transitioning from a net importer to a net exporter of energy in 2020, secured its position as the largest global producer in 2021.
• Economies heavily reliant on crude exports face more substantial economic impact than those with a diverse resource base.

The Petrodollar System and its Effects

The pricing of crude oil is done in U.S. dollars (USD), establishing a crucial connection between the commodity and the currency. Consequently, nations that import oil make payments in the USD, and in the same way, those that export the resource receive payment in the greenback.

This system can be traced back to the early 1970s following the breakdown of the Bretton Woods gold standard. This era witnessed the birth of the petrodollar system, which catapulted the U.S. dollar to its esteemed position as the world's reserve currency. The petrodollar system is used by oil producers and purchasers alike for their USD-based commodity trades.

The fluctuations in the dollar or the price of the commodity prompt a quick repositioning between the greenback and a multitude of forex crosses. These shifts are less apparent in nations without significant crude oil reserves, such as Japan, and more noticeable in countries with ample reserves like Canada, Russia, and Brazil.

Evolution of Oil-Currency Correlations

Many nations, acknowledging the value of their crude oil reserves, capitalized on the energy market's meteoric rise from the mid-1990s through the mid-2000s. They borrowed heavily to fund infrastructure development, expand military operations, and initiate social programs.

However, following the economic collapse of 2008, the bills came due. Some countries adopted deleveraging strategies, while others doubled down, borrowing even more against their reserves in a bid to restore confidence and momentum to their ailing economies.

These increased debt burdens managed to sustain high growth rates until global crude oil prices came crashing down in 2014. This downfall threw commodity-sensitive nations into recessions. Countries like Canada, Russia, Brazil, and other energy-rich regions found themselves in economic distress, needing to adjust to the falling values of their respective currencies—Canadian dollars (CAD), Russian rubles (RUB), and Brazilian reals (BRL).

As selling pressure extended into other commodity groups, the fear of worldwide deflation skyrocketed. This situation tightened the correlation between the affected commodities, including crude oil, and economic centers that do not possess significant commodity reserves like the Eurozone.

Currencies in nations rich in mining reserves but lacking in energy reserves, like the Australian dollar (AUD), plummeted alongside the currencies of oil-rich countries.

The Eurozone Distress

As crude oil prices fell, a deflationary scare took hold of the Eurozone when local consumer price indices turned negative at the end of 2014. Pressure mounted on the European Central Bank (ECB) in early 2015 to implement a large-scale monetary stimulus program. The objective was to halt the deflationary spiral and reintroduce inflation into the system.

The European version of quantitative easing (QE) kicked off in the first week of March 2015 and continued until mid-2018. The European Union saw economic growth in 2019 and the start of 2020, only for the COVID-19 pandemic to trigger a recession. In 2022, the surge in energy prices led to a decrease in household consumption and dealt a blow to an economy that was struggling to recover.

Adding to the economic stress was Russia's invasion of Ukraine, which caused oil prices to surge and raised concerns about Europe's energy security. Sanctions against Russia exacerbated the problem as several Eurozone countries discovered their dependence on Russian oil and gas created an uncomfortable geopolitical predicament.

The EUR/USD vs. Crude Oil Dynamics

For many forex participants, the EUR/USD cross garners their full attention—it is, after all, the most liquid currency market in the world. The currency pair peaked in March 2014, a mere three months before crude oil embarked on a mild decline that accelerated to the downside in the fourth quarter—just as crude dropped from the upper 80s to the low 50s. The Euro selling pressure persisted until March 2015, coinciding with the initiation of the ECB's monetary stimulus package.

As the Euro continued its descent through 2022, reaching as low as $1.05 per euro, crude prices maintained a steady level around $100 by Q2 2022.

The Impact on the U.S. Dollar (USD)

Historically, despite having proven reserves, the United States was a net importer of petroleum. This status changed in 2020 when crude oil production surged and the U.S. began exporting 8.51 million barrels per day. In 2021, the exports increased to 8.63 million barrels per day. This increase established the U.S. as the second-largest energy producer globally, just behind China, and allowed the U.S. to apply sanctions against Russia and increase exports to European nations in 2022.

The U.S.'s ascension in global petroleum production coincided with benefits for the U.S. dollar from the decline in crude oil prices. U.S. economic growth following the bear market was remarkably strong compared to its trading partners, preserving its balance sheets. Additionally, despite the significant contribution of the energy sector to U.S. GDP, the diverse American economy lessened its dependency on that single industry.

Following Russia's invasion of Ukraine in 2022, the U.S. dollar strengthened against many world currencies due to the safe haven effect and escalating inflation, even with soaring oil prices.

The Consequences of Over-Reliance on Oil

Economies that rely heavily on crude oil exports inevitably face more significant economic repercussions than those with a diverse resource portfolio. Russia serves as a perfect case study—energy represented over 65% of its exports in 2014. That figure dropped to just over 60% by the end of 2022 due to decreases in oil and gas prices, trade restrictions, and the global push towards renewable energy.

An unexpected victim of the 2022 oil price surge was Russia. While its economy should have benefited from rising oil prices, the Western sanctions imposed after Russia invaded Ukraine caused the country to struggle economically, leading to a further collapse of the ruble.

The Case of the Ruble

During Russia's economic turmoil in 2015, the ruble became so illiquid that many Western forex platforms halted trading of the currency due to liquidity and capital control issues. This situation prompted traders to start using the Norwegian krone (NOK) as a proxy for the ruble. The Norwegian economy is heavily tied to the energy sector, and as such, it is highly susceptible to crude oil prices. The changes in oil prices over the years have caused significant swings in the USD/NOK.

Understanding the Bonds of Oil and Currencies

The intricate ties that bind crude oil to the world of currencies can be broken down into several crucial factors. These include resource distribution, trade balances, market sentiment, and the inflationary pressures instigated by oil.

The distribution of resources—where they're located and who has access to them—plays a significant role in determining how closely a country's currency will follow the dance of the oil markets. For countries like Canada, Russia, and Brazil, with bountiful oil reserves, the movements in crude oil can directly impact their currency's value.

Trade balances, or the equilibrium of imports and exports, also weigh in heavily on this dynamic. A country with a positive trade balance resulting from high oil exports can see its currency appreciate with rising oil prices.

Market sentiment is another massive influence on this correlation. Perceived changes in oil demand or supply can lead to anticipatory movements in currencies, particularly those of oil-producing countries. Additionally, the inflationary impact of crude oil prices can cause central banks to adjust their monetary policies, which subsequently impacts the value of their currencies.

Conclusion

The landscape of global finance features a delicate, interconnected dance between crude oil and currency pairs. This correlation is driven by the fact that crude oil prices are denominated in U.S. dollars, the economic impact of oil exports on producing nations, and the deflationary effects of falling oil prices that often lead to a corresponding decline in industrial commodities. These intricate dynamics continue to shape the global economy, emphasizing the importance of a keen understanding of these relationships for investors, economists, and policymakers alike.