It is often said in trading oil, that if you look long enough and hard enough you will always find a relationship between two disparate items, and trading oil is certainly no different in that respect. Talk to many oil traders and they will point at a particular correlation that has been successful in the last few years, and it is therefore assumed that this will be successful in the future.

This has typically been the case with the relationship between daily oil prices and the US dollar in the last few years, and since 2006 there has been strong negative correlation between the two, leading many both inside and outside the industry to speculate that this relationship now provides the ideal basis for trading oil, and indeed has almost become the de facto standard.

Look back just four years however, and the exact opposite was occurring, with higher oil prices correlating positively with a stronger dollar. So what exactly is this relationship and in trading oil can we draw any meaningful conclusions from the relationship. Let’s consider the facts and below is a chart which shows the correlation between oil and the dollar index of the last 13 years. If you would like an explanation of the dollar index please just follow the link here.

Correlation Between Oil Prices & US Dollar

Correlation Between Oil Prices & US Dollar

The chart alongside shows the correlation between the US dollar index and light crude oil, from 1995 until 2005, and as can be clearly seen, the correlations swings between negative and positive throughout the period. From 1995 to 1997 there was strong positive correlation followed by 2 years of negative which them reversed again back to positive before a reversal to today’s relationship which is negative correlation again with rising oil prices and a falling US dollar. So the question to ask is whether we can draw any meaningful conclusions from these trends or whether they are simply an indication of the broader economic effects of changes in oil prices, coupled with a stronger or weaker US dollar?

If we start with the negative correlation that has been in place for the last few years, there are several possible explanations. The first is the fact that oil exporters economically rely less on the US than ever before, and in general ( and increasingly ) look to purchase European manufactured goods and products. As an example of this trend in the 1970’s approximately 19% of imports were from America, now they are closer to 9%, almost halving in the period, whilst imports from the EU have risen dramatically. So a simple conclusion is the higher the oil price, the more goods are purchased in Euros rather then US dollars.  Another common explanation is that commodity prices tend to benefit from a weaker dollar because a declining US currency tends to makes dollar based commodities cheaper for non-US buyers.

A further option may be the oil traders themselves – as with any trading one can argue that this is a self fulfilling prophesy. Many trading oil and other commodities will have a short US dollar, long oil futures trade set as a hedge. As one senior city analyst put it recently ” if traders think there is a relationship and trade on the correlation, then inevitably this can reinforce price movements” – this is much the same as can be argued in the FX markets, when studying Fibonacci, or indeed any major support or resistance level. After all, trading oil exchanges are the same as any other market, we are all looking at the same oil trading charts!

My own personal view is that it is none of these, but simply the combination of economic cycles that come and go in any global economy, and the general perception that world demand is growing faster than new supplies are being found. China and India have been the principal drivers in this respect. Whatever your view of speculators may be, good or bad, and there is certainly an argument to say that the current oil trading price is inflated by around 50%-60%, the general economics will always prevail no matter the weight of speculators in the market. The dollar weakness was caused primarily by problems in the sub prime housing market with increasing energy costs only becoming a contributory factor at a later stage.

In the last few months we have seen oil prices fall fast, then return back to the $70 a barrel (with some analysts forecasting a consolidation at around $80 – $85, the level at which producers need oil to trade in order to maintain current production levels), and strength returning to the dollar with a view that the US economy may have reached a bottom. Recent events with Lehman Brothers may suggest however that the worst is not yet over. As Nauman Barakat VP of global energy futures at Macquarie Futures said recently ” At some point prices of oil commodities have to reflect underlying supply and demand fundamentals, no matter what the dollar is doing against the Euro” At present this does not seem to be the case, but no doubt this will aspect of oil trading will return in due course.

In summary for you trading oil contracts, whether in spot oil or futures oil, I would treat any so-called correlation as a trading signal with great caution, and certainly not as any type of guarantee of future prices. Whilst this relationship may continue for some time, it is by no means a signal for oil trading.

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