Monday, April 20, 2015

Dollar Appreciates and the Price of Oil Decreases. WHY?

The Wall Street Journal has an article today on the relationship between the strength of the US dollar and the price of crude oil:

Oil Prices Fall on U.S. Dollar Strength

Most major commodities are traded in US dollars, whether the trading partners use US dollars in their economies or not.  It is simply the common currency for international trade. So, trading partners DO care a lot about US dollar exchange rates as it helps in determining profitability.

I am going to use a VERY simple example to try to get this point across. I know it can be a difficult concept for students, and teachers as well.

In the country of "Hayward-istan" oil is the main commodity produced and sold on the world market. Oil is priced in dollars, so when I sell my oil I receive US dollars for it.  I can then take those dollars and exchange them for the currency of Hayward-istan---the Hayward Dollar.

Right now the going exchange rate is $1.00 US exchanges for 2 Hayward Dollars, or the inverse, 1.00 Hayward Dollar exchanges for $.50 US cents.

To make the math easy, assume one barrel of oil currently fetches $100.00 US on the world market. This means when I sell a barrel and exchange it in my currency I will receive 200.00 Hayward dollars.

 Easy enough.

Now assume the exchange rate changes to $1.00 exchanges for 3.00 Hayward dollars or 1.00 Hayward dollar exchanges for $.33 US cents.  The US dollar has APPRECIATED (it "buys" more Hayward's) and the Hayward dollar has DEPRECIATED (it "buys" fewer dollars (or cents)) in value.

Nothing concerning the fundamentals of the oil market (demand and/or supply) has changed---only the value of the currencies used to trade oil has changed. So, now when I go to exchange my oil for dollars and then exchange it back into Hayward dollars I have 300.00 instead of 200.00. Ka-Ching! Instant windfall of 100.00 more Hayward dollars, or in percentage terms, 50% more than before.

If the market going to let me get away with this?

Nope. If the markets were to work efficiently (BIG IF, but it is an assumption I will make for illustration purposes), the US dollar price of oil will adjust so I am not better or worse off than before (again, just go with me on this).

With the new exchange rate of $1.00US = 3.00 Hayward's (or 1.00 Hayward = $.33 US cents), in order for me to just receive the old 200.00 Hayward dollars, the price of oil would decrease to $66.66 US dollars.

In other words, when I took my oil to market I would get $66.66 for a barrel.  I would exchange that $66.66 for 200 Hayward dollars---$66.66 US dollars X 3.00 Hayward's = 200.00 Hayward's.

SAME AS BEFORE the currency change.

If the dollar were to depreciate and the Hayward appreciate, the OPPOSITE would occur.

At a very basic level, I hope this helps you understand the relationship described in the article.  It is not the whole story but it is an essential part of it.

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