May 27, 2008
The U.S. Dollar Hits an Oil Slick
ByMartin Feldstein
The rapid rise in the price of oil and the
sharp depreciation of the dollar are two of the most noteworthy developments of
the past year. The price of oil has increased by 85 percent over the past 12
months, from US$65 a barrel to US$120. During the same period, the dollar fell
by 15 percent relative to the euro and 12 percent against the yen. To many
observers, the combination of a falling dollar and a rise in oil prices appears
to be more than a coincidence.
But
what is the link between the two? Would the price of oil have increased less if
oil were priced in euros instead of dollars? Did the dollar¢s fall cause the
price of oil to rise?
And how did the rise in the price of oil
affect the dollar¢s movement?
Because the oil market is global, with its
price in different places virtually identical, the price reflects both total
world demand for oil and total supply by all of the oil-producing countries.
The primary demand for oil is as a transport fuel, with lesser amounts used for
heating, energy, and as inputs for petrochemical industries like plastics. The
increasing demand for oil from all countries, but particularly from rapidly
growing emerging-market countries like Chinaand India, has therefore been, and
will continue to
be, an important force pushing up the global price.
The thinking behind the question of whether
oil would cost less today if it were priced in euros seems to be that, since
the dollar has fallen relative to the euro, this would have contained the rise
in the price of oil.
In reality, the currency in which oil is
priced would have no significant or sustained effect on the price of oil when
translated
into dollars, euros, yen, or any other currency.
Here is why. The market is now in
equilibrium with the price of oil at US$120. That translates into 75 euros at
the current exchange rate of around US$1.60 per euro. If it were agreed that
oil would instead be priced in euros, the quoted market-equilibrating price
would still be 75 euros and therefore US$120.
Any lower price in euros would cause an
excess of global demand for oil, while a price above 75 euros would not create
enough demand to absorb all of the oil that producers wanted to sell at that
price.
Of course, the rate of increase of the price
of oil in euros during the past year was lower than the rate of increase in
dollars. The euro price of oil last May was 48 euros, or 56 percent below its
current price.
But that would be true even if oil had been
priced in euros.
The coincidence of the dollar decline and
the rise in the oil price suggests to many observers that the dollar¢s decline
caused the rise in the price of oil. That is only true to the extent that we
think about the price of oil in dollars, since the dollar has fallen relative
to other major currencies. But if the dollar-euro exchange rate had remained at
the same level that it was last May, the dollar price of oil would have
increased
less.
The key point here is that the euro price of
oil would be the same as it is today. And the dollar price of oil would have
gone up 56 percent. The only effect of the dollar¢s decline is to change the
price in dollars relative to the price in euros and other currencies.
The high and rising price of oil does,
however, contribute to the decline of the dollar, because the increasing cost
of oil imports widens the US¢ trade deficit. Last year, the USspent US$331
billion on oil imports, which
was 47 percent of the UStrade deficit of US$708 billion.
If the price of oil had remained at US$65 a
barrel, the cost of the same volume of imports would have been only US$179
billion, and the trade deficit would have been one-fifth lower.
The dollar is declining because only a more
competitive dollar can shrink the UStrade deficit to a sustainable level.
Thus, as rising global demand pushes oil
prices higher in the years ahead, it will become more difficult to shrink the
UStrade deficit, inducing more rapid dollar
depreciation.
Martin Feldsteinis Professor of Economics
at Harvard and President of the National Bureau for Economic
Research.http://www.realclearmarkets.com/articles/2008/05/the_us_dollar_hits_an_oil_slic.html
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