Oil, as a primary source of energy, is the drug that runs through the veins of the world economy.
Canada, one of the world’s leading oil producers, sells nearly 3 million barrels of oil and petroleum products to the United States every day.
This makes it the largest oil supplier to the United States!
Because of the quantities involved, there is a high demand for Canadian dollars.
Also, keep in mind that Canada’s economy is heavily reliant on exports, with over 85% of its exports flowing to its larger brother down south, the United States.
As a result, how US consumers react to fluctuations in oil prices can have a significant impact on USD/CAD.
If demand in the United States rises, manufacturers will need to order additional oil to keep up. This may cause oil prices to rise, causing the USD/CAD to decline.
If demand in the United States dips, manufacturers may decide to take a break since they do not need to produce more goods. Oil demand could fall, putting pressure on the CAD.
Between 2000 and 2016, oil has a 93% negative connection with USD/CAD.
When oil prices rise, the USD/CAD falls. When oil prices fall, the USD/CAD rises.
To emphasize the correlation, we can flip USD/CAD to show how both markets move almost simultaneously (i.e., crude oil will rise in value with the Canadian dollar as the US dollar falls…and vice versa). Check out the graph below:
The USD and Oil Relationship
The price of oil has historically been inversely tied to the price of the US dollar.
This relationship can be explained using two well-known premises.
- Around the world, a barrel of oil is priced in US dollars. When the US currency is strong, it takes fewer US dollars to purchase a barrel of oil. When the US currency falls, the price of oil rises in dollar terms.
- Historically, the United States has been a net importer of oil. Rising oil prices increase the US trade deficit because more dollars are required to be sent abroad.
The former is still true today, but the latter is not. The U.S. shale revolution has drastically expanded domestic petroleum production, owing mostly to the effectiveness of horizontal drilling and fracking technology.
In reality, the United States became a net exporter of refined petroleum products in 2011, and has since surpassed Saudi Arabia and Russia as the world’s largest producer of crude oil!
The United States is presently nearly 90% self-sufficient in terms of total energy use, according to the Energy Information Administration (EIA).
The technological breakthrough of fracking has upended the oil market’s status quo.
Oil imports have declined as US oil exports have soared. This indicates that rising oil prices no longer contribute to an increase in the US trade deficit, but rather aid to reduce it.
As a result, the previously strong inverse link between oil prices and the US currency has weakened.
Over the past eight years, the rolling 6-month correlation coefficient was mostly negative but that’s starting to change.
Given the changing dynamics of the global energy market, it is not surprising that this historically negative correlation will spend more time in positive territory.
Oil’s connection with the United States appears to be evolving, reflecting the country’s expanding significance in the global oil business.
Is the dollar evolving into a petrocurrency? A currency used by countries such as Canada, Russia, and Norway that export so much oil that oil profits account for a major portion of their GDP.
The United States has become the new swing producer of oil, which means that its output has the most sway over global oil prices. It was Saudi Arabia before the shale revolution.
In the coming years, the United States may begin to trade more like a petrocurrency. As the US continues to increase its proportion of oil exports over imports, oil revenue will play a larger role in the US economy, and the US dollar may begin to behave like a petrocurrency, meaning that when oil prices rise, so does the currency.
Understanding why the dollar has historically traded inversely to the price of oil and why the link has lately decreased might assist traders in making more informed trading decisions as the global economy evolves.
