Are Media Right About a Lower Dollar Causing Higher Oil Prices?

A fairly common media meme during the past year or so has been that the continually declining value of the dollar is driving up oil and gas prices (image courtesy Slate).

In the past three months alone, there have been over 100 stories involving this very subject, including this March 10 piece from U.S. News & World Report entitled "Why Gas Prices Rise as the Dollar Falls (emphasis added):

Here's one of those complex economic truisms the financial press assumes everybody understands: A big reason oil and gas prices are hitting record highs is that the dollar is hitting record lows.

The beauty of this "truism" is that it allows media outlets to blame oil and gas price rises on the Bush administration, as everybody knows that the lower dollar is all their fault (wink, wink...nudge, nudge).

Of course, an examination of oil and Dollar Index charts does show an inverse correlation, meaning that as oil prices rise, the dollar drops and vice versa (charts provided by TradingCharts.com):

Looks like a pretty strong correlation, correct? Yet, if you recall from your high school chemistry and/or statistics, correlation does not mean causality.

Sadly, akin to how media members and Al Gore believe a correlation between rising CO2 levels in the atmosphere over the past 150 years and rising global temperatures means the former is causing the latter, they also believe that this inverse correlation between a falling dollar and rising oil prices is similarly conclusive.

From that previously cited U.S. News article, here's one explanation from Kristin Forbes, a professor at MIT's Sloan School of Management and former member of the White House's Council of Economic Advisers:

Oil is priced in dollars on the world market. When the dollar is weaker, foreign currencies are stronger, by definition. That means people in other countries can buy more oil for the same amount of money. So let's assume oil is $100 per barrel, and $100 is equal to 70 euros. If the euro appreciates against the dollar by 10 percent, then instead of 70 euros it will take only 63 euros to buy one barrel of oil. So that oil becomes cheaper to foreigners, and they can buy more.

Well, this would be the case if the value of the euro was rising as oil prices remained stable. However, that's not been the case. In fact, although the euro has risen against the dollar in the past seven years, the percentage movement in oil's rise is significantly greater:

So, as can be plainly seen, the euro has less than doubled in value against the dollar in the past seven years. At the same time, oil has gone up fivefold.

As such, despite the dollar's fall, oil prices in Europe in real terms (meaning including currency translation) have still risen dramatically thereby refuting the contention that the dollar's decline in recent years has made oil cheaper abroad resulting in higher demand.

To make this clearer, in 2001, when oil was at $20/bbl, and the euro was worth $0.90, that meant a barrel of oil cost about 22 euros. Today, with oil at let's say $100/bbl, and the euro at let's say $1.50, this means oil costs almost 67 euros, or three times what it did in 2001.

Think this rise is what's responsible for Europe's increased demand for oil and gas in Europe? Or, is it more likely being caused by a growing economy?

In the end, I think most liberal media members and some economists have this all wrong, and that it is increasing oil prices that is adding to the dollar's decline. Since oil is traded around the world in dollars, and America imports such a huge amount of oil, as oil prices rise, America is exporting more and more of its currency abroad.

Consider what's happened to the Canadian dollar in the past seven years, and that this is the country America imports the highest amount of oil from:

Pretty big move, yes? How much of it might be due to Canadian oil producers converting U.S. dollars into Canadian dollars on a regular basis?

After all, since oil is traded in dollars, when we buy oil from Canada, we do it in U.S. dollars. That forces the Canadian oil producer to convert those U.S. dollars to Canadian dollars, correct? And, how do they do that? By selling U.S. dollars and buying Canadian dollars.

This drives down the value of the U.S. dollar, and up the value of the Canadian. Make sense?

To be sure, there are many other factors in determining currency translations, primary amongst them being interest rates. As money is always chasing yield, countries with higher interest rates typically have stronger currencies.

Consider that after the Federal Reserve's interest rate cuts last week, our Fed Funds rate is currently 2.25 percent. Compare this to the 4.00 percent rate of the European Central Bank, and you can imagine that international investors are much more interested in fixed income vehicles based in euros over those denominated in dollars.

Sadly, such logic and economic reality eludes most media members looking to blame everything on George W. Bush.

Speaking of last week's Fed action, one would have expected such a huge reduction in interest rates to cause a further weakening of the dollar unless coordinated with interest rate cuts by central banks around the world. Yet, that's not what happened.

In fact, the dollar staged a huge rally in the final three days of trading last week after the Fed cut the Funds rate by 75 bps:

At the same time, oil plummeted:

Frankly, I think what we saw last week proved that media have this all backwards, and that higher oil prices are negatively impacting the dollar rather than vice versa. Why?

Well, because given the Fed's cut in interest rates Tuesday, if oil is trading off of the dollar, the dollar should have declined after the Fed's announcement, and oil risen.

Instead, I believe the precipitous decline in oil last week trumped the Fed's interest rate cuts as far as currency traders were concerned, and the dollar rallied on lower oil prices.

Who's right? Well, if oil continues lower as do U.S. interest rates, and the dollar continues to rally, one would have to conclude that the dollar is trading off of oil prices and not the other way around.

Does that mean media will change their tune? Of course they will -- once a Democrat, heaven forbid, is back in the White House.