Thursday, August 7, 2008

US dollar gains, oil slides, good for consumers

On July 11, 2008, the spot price of West Texas Intermediate crude oil (WTI) was $145.66/barrel, or 100% higher than the year before. On August 1, 2008, the WTI spot price was $123.26/barrel, or 60% higher than the year before. Today, the WTI spot price closed at $119.89/barrel, or 67% higher than the year before. Oil prices are driven by supply and demand; however, recently they have been also driven by the value of the U.S. dollar.

Oil is a global market and universally priced in U.S. dollars (USD). Theoretically, there should be a negative relationship between the value of the USD and the price of oil. As the value of the USD falls, oil producers raise the price of oil in order to make up the profit drag coming from the falling USD, and vice versa. But we all know that theory and practice are often two very different animals.There is a very tenuous relationship between the value of the USD and the price of oil using monthly data spanning the years 1985 to 1999. Tenuous is a euphemism for the relationship that did not exist (R2=0.017 means the estimation is not significant). If anything, the relationship between the USD and the WTI price of oil is positive; an increase in the value of the USD corresponds with an increase in the price of oil. However, recent history shows a much stronger relationship.
There is a robust and negative relationship between the value of the USD and the price of oil spanning the years 2000-2008 (R2=0.848, which is close to 1 and means that the estimation is very significant). The chart shows that for each 1% rise in the USD, there is a 3.3% reduction in the price of oil. Oil is very responsive to the value of the USD.

The recent news on oil, gas, and the USD is irrefutably good! Oil has been the biggest risk to the US outlook. If oil prices continue to decline, the economy will improve.

It goes like this: Rising value of USD → falling oil prices → falling gas prices → falling portion of consumer income going to gas → more spending in other areas → stronger economy.

Please leave comments. Best, Nontruths

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