Odd Correlation Between Oil and the Dollar

Ivan Martchev  |

by Ivan Martchev

It used to be said that a strong dollar meant weaker oil prices and vice versa, but a lot has changed in that relationship in the last year. As the dollar kept rallying, the oil market stayed firm as the whiff of new Iran oil sanctions kept oil prices stronger than they otherwise might have been. Then, Iran oil sanctions turned out to be not as severe as feared and the hoarding of oil leading up to the sanctions, combined with a sharp downturn in the Chinese economy took the price of crude from $77 to $42 in a single quarter!

To be fair, it’s not just the strong dollar itself that made oil historically weak, but what caused the dollar to be strong. The dollar would normally be strong in Federal Reserve tightening cycles, which tended to slow the global economy and cause the dollar to trade higher on interest rate differentials. There are multiple other factors, in addition to this well-established feedback loop affecting oil prices.

Recovering to around $64 at present, one would think that all is well in the crude oil market, but we again face a very firm dollar, courtesy of Fed balance sheet runoff activities (aka QT) and the ECB’s belated QE activities, as well as aggressive Chinese fiscal and monetary stimulus that affects the demand side of crude oil markets. After all, China is the biggest importer of crude oil on global markets and a pickup in economic activity in China impacts prices, particularly in the seasonally-strong March-September period.

Crude Oil versus United States Dollar Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Chinese sharp slowdown and rebound, Iran oil sanctions, and a rather messy global economy have caused the correlation between the dollar and crude oil to break down rather dramatically in the past year. This also causes problematic correlations between oil and various commodity indexes, where energy is often the heaviest-weighted component.

But what about industrial metals, which are less political. but equally economically-sensitive?


Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Industrial metals have also perked up with the rebound in energy prices, but they are not as “perky” as crude oil. Could it be that the Chinese economy has experienced an economic rebound, while the rest of the world has not done as well, resulting in weaker industrial metals and stronger crude oil?

Turning around an economy the size of China is like turning around an aircraft carrier. China managed to arrest their economic deceleration yet again, with their infamous lending quotas. Frankly, I have no idea how long this “forced lending” business can maintain an expansionary economic cycle that is now 26 years long. I only know that they cannot extend it into perpetuity, which raises interesting questions as to the severity of the downturn when it arrives, as so many problems and unproductive uses of capital have been swept under the proverbial Beijing carpet.

More Divergences in the Energy Space

One correlation that has been holding up well is the one between the MSCI Emerging Markets Index and crude oil. It has been surreal how long it has lasted and keeps on holding. A large part of the MSCI index is economies that benefit from high crude oil prices, while the other part is economies that use a lot of crude oil. When demand for crude oil is high, both consumers and producers do well.

MSCI Emerging Markets Free Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Emerging markets have rebounded dramatically with the rebound in crude oil prices, but I think the situation has been disproportionately impacted by China, which has an estimated GDP of $14.2 trillion for 2018 and as such is bigger than the next 10 emerging economies combined, so if China is not doing well the rest of the emerging markets universe is not doing well, either, save only for India. This is because India is a somewhat closed economy driven by its own internal dynamics and tends to benefit tremendously from lower oil prices (when China is not doing well). You could say that when it comes to economic performance, in a large way what is bad for China to a considerable degree is good for India.

Philadelphia Oil Services Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

When it comes to crude oil, there is something that doesn't quite fit the picture. The PHLX Oil Service Index took out its low from 2008 and the oil price didn't. On the other hand, the oil price did take out its low from 2008 in early 2016 but the OSX index didn’t. The point is that this index houses oil service companies that are very sensitive to oil prices and drilling budgets. An oil price at $64 does not imply an OSX level of $99 but more likely north of $150. Either the OSX index will rally or the stocks in the index are sensing a weakness in the crude oil prices that is not reflected by the price of crude oil … yet.

I think the rebound in crude oil prices in 2019 is primarily driven by China. I think this strong crude oil price is very misleading, as a rebound in the Chinese economy is driven by their infamous lending quotas. That does not mean that the rest of the world is doing all that well, save for the United States.

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