Rising oil prices & a weak US dollar

Historically, the dollar’s strength in the face of rising energy prices was principally a function of two forces. First, oil is transacted in dollars. As the price of oil rises, non-US-based oil buyers - those whose economies are not dollar-based - need to purchase more dollars in order to purchase a given amount of oil. Traditionally, this increases the demand for dollars and pushes up the price of the dollar relative to other currencies, hence creating a stronger dollar.

Second, periods of rising energy prices have typically increased demand for US-based (and dollar denominated) assets because of the overall strength of the US market. To the extent that rising energy prices have historically signaled oncoming instability in the world’s economy, the demand for US-based financial assets spoke to the past stability of the US commercial sector, as well as our legal, political, and financial institutions. Put directly: The US has historically been viewed as the safe port in a storm. But in order to get in - buy US stocks, bonds, and other financial instruments-you first have to buy dollars. This placed additional demand on the dollar.

What has changed that the world is now experiencing a weak dollar in the face of high oil prices? The principal answer is the state of the US economy. The US federal government is running record high budget deficits. The total debt has now hit $7.9 trillion dollars. Our current level of debt is nearly eight times higher today than in 79-80 period, and over sixteen times higher than the 73-74 period. (Fig. 2) This spending pushes dollars out into the marketplace as the government finances its incremental expenditures, not through additional tax revenues, but through increased borrowing. In addition, consumer savings is also down, further increasing the supply of dollars in the global marketplace.

So, what happens at this current and unusual trading juncture? What does a weak dollar do? It depends, in part, on the perspective from which you ask the question. The primary impact for the average US consumer has been minor. The analogy is buying milk at the grocery store. Do the consumers feel the impact of the weak dollar when they buy milk, which is already denominated in dollars? Not directly. The most significant impact may be the recent rise in short-term interest rates from their 40-year lows, as the US Federal Reserve Bank combats fears of inflation partly due to rising energy prices.

That said, higher energy prices in combination with a weak dollar can have significant sector-specific and macro-economic impacts. Who wins and who loses is a function of the impact of these two forces and, therefore, is specific to particular classes of buyers and sellers.

Foreign manufacturers, for example, whose currency is not pegged to the dollar, such as those located in European and Asian countries, have significant cost advantages relative to their competitors located in dollar-based economies. The reason is simple. While prices of energy have increased for all consumers, the relative change in the value of currencies means that energy prices have not increased uniformly for all buyers. Fig. 3 highlights this point. It compares the cost of a barrel of oil today in dollars to the same cost in British pounds. The barrel is 43% less expensive for British buyers than it is for US buyers. (In July 2005, the value of US dollars ($) to British pounds (£) was 1.75.) The cost is lower (relative to a stronger dollar) because the weak dollar means British buyers have to use fewer pounds to buy the dollars necessary to purchase the oil. The same would hold true for any non-dollar denominated currency, although the actual difference would vary as function of the strength of the particular currency. The weak dollar offers an advantage because it lowers the relative cost of energy.

It would, in contrast, appear that the weak dollar offers an advantage to US-based exporters. The weak dollar serves to make their products relatively less expensive in the global marketplace. This, however, also requires a more careful examination of the two forces, as the higher energy costs may overwhelm any benefits arising from a weaker dollar. The US chemical sector illustrates this point. As little as five years ago, this sector was a net exporter and, consequently, a significant positive contributor to our trade account with the rest of the world. In the face of higher rising energy costs, that has now turned around. Even in the wake of a relatively cheap dollar-which would serve to lower the relative price of products from US chemical manufacturers for their foreign customers-the sector is now shutting in marginal facilities while the US has become a net importer of chemical products.

For US companies that have overseas operations, the weaker dollar can positively impact their bottom line. If they get paid in foreign currency, a given amount of such currency will convert into more dollars. Again, this assumes all else is equal. For importers or US consumers of imported goods, the weaker dollar hurts them. To the extent the domestic energy sector, for example, buys foreign-produced parts, inputs or services, those services become more expensive. In sum, the impacts of the weaker dollar really depend upon the “who” implicit within the question.

The financial sector presents its own set of winners and losers. The weak dollar makes it easier for foreign investors to “enter our port” by making our assets relatively cheaper. It takes less marks, pounds, rials, and so forth, to buy a given amount of US-based assets. Is there a foreign refiner who wants a US-based presence? Does a European gas marketer want to expand its operations in the US mid-stream sector? The weaker dollar makes it less expensive to buy US-based energy assets.

In this sense, the weak dollar makes borrowing easier for the US economy and helps mitigate inflationary pressures. It lowers the cost of credit by making US financial assets comparatively more attractive to the world’s creditors. This becomes particularly significant as the US government continues to borrow at an ever-expanding rate to meet its obligations. Foreign entities loan us dollars; we loan them US-based assets. They give us dollars, we give them IOUs. Of course, if foreign entities begin to doubt the strength of the US economy, for example, due to the continuing growth in the US budget deficit, and subsequently stop loaning us dollars, then we will be entering another “whole new world” and it won’t be pleasant. $

About the authors

Kenneth Grant is a managing director with Lexecon, an FTI company, and is based in Cambridge. He specializes in competitive analysis, market value, and public policy. He has analyzed market structures and economic factors impacting firm behavior and competitive outcomes on behalf of clients in many industries, including oil, natural gas, and electricity.

Gary Alden is a former manager with Lexecon, an FTI company.

The views expressed in the article are held by the authors and are not necessarily representative of FTI Consulting.