Strong Dollar Could Cap Oil Prices

The strength of the U.S. dollar poses an obstacle to further gains in oil prices.

President Trump’s trade war with China, which is still in its early stages, has already battered the yuan. The dollar has gained more than 8 percent against the Chinese currency since March. As Reuters points out, in dollar terms the price of Brent oil has climbed 9 percent this year, but in yuan terms oil is now nearly 14 percent more expensive.

But it isn’t just the yuan that has been knocked down a peg or two by the greenback. The U.S. dollar index is at its strongest in a year, pushed along by steady rate tightening from the U.S. Federal Reserve and solid GDP growth.

oil storage

There is a bit of a feedback effect at hand as well. As the Fed tightens rates and pushes up the dollar, emerging market currencies suffer from sudden shocks, sometimes severe. Argentina, Brazil, Turkey and South Africa have seen significant depreciation in their currencies this year. As capital flees some of these emerging markets and flows into safe-haven assets, such as the U.S. dollar, it only magnifies the divergence between the greenback and other currencies.

The problem for many emerging markets is that oil prices have been going up at the same time. Typically, oil prices trade inversely to the U.S. dollar. A stronger dollar makes oil more expensive to much of the world, so oil prices typically fall as the dollar rises. But the dollar and oil have been climbing in tandem for much of this year. This amplifies the pain for many consumers around the world.

Painful price increases threatens oil demand. To some extent, governments around the world are trying to cushion the blow through price caps, fuel subsidies and currency support. Those market interventions from several countries could keep oil demand growth from diving too much, Bank of America Merrill Lynch said in a note in early June.

But those measures come at a huge cost to public coffers, and might not be enough to stave off demand destruction and/or economic slowdown. The hit to oil demand will be much larger than would be the case if the dollar had not strengthened. Dealing with a rise in oil prices is one thing, but for motorists in emerging markets to swallow double-digit price increases at the pump, driven by weakening currencies relative to the dollar, is an entirely different thing.

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Moon Kil Woong 7 months ago Contributor's comment

However, Mid East tensions and actions can always counter this. The issue is #oil is rising despite a stronger dollar which is a bit worrisome.

Danny Straus 7 months ago Member's comment

Sorry for the newbie question, but can you explain why that is so worrisome, Moon?

Moon Kil Woong 7 months ago Contributor's comment

If oil rises when the dollar is strong then the real worry is if the dollar weakens which can make oil and inflation become a real problem really fast. This is why we have oil reserves, should not run massive deficits, and engage in overly loose monetary policy like QE.