The link between the US dollar and the oil price is complicated. During the 1990s, academic work suggested that the link was such that a 10% rise in the real oil price would tend to boost the US dollar by around 1.5%.
This reflected the fact that as oil prices rose, it increased the transactions demand for US dollars to purchase crude oil. In addition, it implied a transfer of wealth from oil-consuming to oil-producing nations, particularly in the Middle East, that then recycled these petrodollars into US securities, benefiting the US dollar from a capital flow perspective.
Finally since the US is an oil-producing country,it led to an improvement in the country’s terms of trade relative to Europe.
However since 2001 this link between the oil price and the US dollar has collapsed as rising oil prices have coincided with a falling US dollar. In Bank's view, this was linked to the fact that rising oil prices led to a significant deterioration in the US’s trade deficit.
Indeed oil and petroleum products represent around 50% of the entire US trade deficit. As a result, in an environment where US interest rates were declining and the US basic balance was deteriorating, higher oil prices were associated with a weaker US dollar.
Today, attention is once again turning to the scenario of how a new long-term uptrend in the US dollar might affect oil prices. If it does, it would suggest that the causality between oil prices and the US dollar will have been turned on its head.
In a sense we can see a case for a rising US dollar capping oil prices since an appreciation in the US dollar would then raise the cost of imported crude oil for consuming nations, notably in Asia, and therefore curb global oil demand at the margin.
Asia and notably China’s increasing dependence on imported crude oil has been growing at a significant rate, reflecting not only healthy oil demand growth rates and flat domestic production growth but also demand for commercial as well as strategic stockpiling purposes.
This is in direct contrast to the declining trend for imported crude oil in the US driven in large part to rapid growth in domestic US supply, notably shale oil supply. Indeed the gap between US and China’s crude oil imports has narrowed sharply in the past year and it appears that China may be on the path towards overtaking the US as the largest crude oil importer.
On the supply side, an appreciating US dollar might also on the margin increase the attractiveness for oil exporting nations to exploit existing resources and increase oil production in what will become an appreciating asset, since oil is priced in US dollars.
"Given the bullish view that our colleagues in FX research hold for the US dollar, we examined what that would imply for crude oil prices. Based on their forecast, our model implies that by year-end, Brent crude oil will have dropped by 16% from year-end 2012 Brent prices." Deutsche Bank noted.
This implies Brent prices at roughly USD93/bbl by the end of this year, implying a weaker oil price environment relative to the Bank's current deck of oil price forecasts. Consequently, the stronger US dollar forecast could well mean a redrawing of the price deck.
While the FX view does indeed imply a weaker oil price environment, we note that there are of course key factors that could come into play that may stem the price action. One key element of this is OPEC.
A precipitous drop in prices would likely result in OPEC action to defend price levels in the form of supply curbs. A sustained drop below USD100/bbl is likely to be the catalyst for OPEC action.
The Bank notes that their colleagues in Emerging Markets research estimate that the breakeven oil price level on a fiscal and budgetary basis for key Middle Eastern OPEC members is around $80/bbl on a Brent basis,.
“Consequently, we expect an oil price drop to double-digit levels and slide towards that USD80/bbl mark would likely prompt agitation among OPEC member countries.” the Bank concluded.
Source: Deutsche Bank