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International Journal of Energy Economics and Policy Vol. 3, No. 4, 2013, pp.341-351 ISSN: 2146-4553 www.econjournals.com The Links between the Price of Oil and the Value of US Dollar Yi Zhang Suffolk University, Boston, USA. Email: [email protected] ABSTRACT: Using monthly data, this paper studies the cointegration between the real price of oil and the real effective exchange rate of US dollar allowing for structural breaks. Contrary to the conclusion from previous literature, this paper finds that the cointegration between the oil price and the value of US dollar does not significantly exist unless the effects of two structural breaks in the past, November 1986 and February 2005, are controlled for. Keywords: Oil price; Exchange rate; Cointegration JEL Classifications: C32; F31; Q43 1. Introduction The US dollar is typically used as the invoicing currency in international crude oil trading. Therefore, the dollar crude oil price is believed to be influenced by fluctuations in the value of US dollar. At least since 2002, the dollar price of oil has tended to rise at the same time that the US dollar has depreciated, in terms of real effective exchange rate (hereinafter referred to as the ‘US dollar exchange rate’). This raises the possibility that co-movements between the price of oil and the US dollar exchange rate exist in the long run, and a depreciation of the US dollar should be associated with a rise in the dollar price of oil. Depreciation of dollar makes oil relatively cheaper in countries with appreciating currencies such as the euro and yen (Alhajji 2004). If the US dollar exchange rate really matters in setting the price of oil, it is appropriate to raise the question of the choice of currency for oil invoicing. Therefore, it is interesting and important to investigate the linkage between the dollar oil price and the US dollar exchange rate. With a longer and more up-to-date data, I do not find a long- run relationship between the price of oil and US dollar exchange rate, which is also found by Ferraro et al. (2011), and Chen et al. (2013). However, in this paper, I show that the long-run relationship significantly exists with the consideration of two breakpoints. One is in November 1986, when the oil pricing system changed from the refinery margin netback to formula netback pricing. The other one is in February 2005, when the world oil demand increased, particularly coming from the emerging economies. A lot of papers have studied the long-run relationship between the price of oil and the US dollar exchange rate, and most of them only find causality moving from the price of oil to the exchange rate, not vice versa, which is not consistent with the analysis mentioned above. Some have studied the theory underlying the links between the price of oil and the US dollar exchange rate. For the effect of the oil price on the dollar exchange rate, Krugman (1983) and Golub (1983) explain such effects through the balance of payments. They both argue that a rise in the oil price will bring a wealth transfer from oil-importing countries to oil-exporting countries, and its impact on the exchange rate will depend on the portfolio preferences of oil-exporting countries in the short run, but will depend on their import preferences in the long run. They find that oil-exporting countries, typically OPEC countries, have a preference for US dollar-denominated assets. When the oil price rises, it increases the income of oil-exporting countries. Then, in the short run, these countries use the higher income to purchase more US dollar-denominated assets, which causes the US dollar to appreciate. In the long run, higher income will transfer into higher expenditure. For example, suppose these countries use the higher income to purchase European goods. Then they have to exchange US dollars for Euros, which eventually leads to a depreciation of the US dollar. 341 International Journal of Energy Economics and Policy, Vol. 3, No. 4, 2013, pp.341-351 The effect of the dollar exchange rate on the price of oil can be found in Haughton (1989) and Alhajji (2004). An exogenous exchange rate change will bring about an oil price adjustment separately on the oil demand and oil supply sides. On the demand side, once the dollar depreciates, oil in other countries is cheaper in local currencies, which means a higher quantity demanded for oil, and hence a higher world demand for oil. Then the oil price rises. On the supply side, the oil exporting countries lose purchasing power when the dollar depreciates, and in order to defend losing purchasing power, they may curtail supply, which will increase the oil price. Other researchers have used econometric techniques to investigate the link between the price of oil and the US dollar exchange rate. Some of them just focus on the bilateral linkage between these two by employing cointegration tests and error correction models to explore the long-term relationship, and the direction of causality between them over time. They all find that these two series are cointegrated, and the oil price causes subsequent changes in the US dollar exchange rate (Amano and Norden, 1998a; Amano and Norden, 1998b; Benassy-Quere et al., 2007; Chaudhuri and Daniel, 1997). Chen and Chen (2006) use panel data covering G7 countries from 1972 to 2005 to explore the relationship between the real oil prices and the real exchange rate. Using a panel cointegration test and panel prediction regression, they show that the real oil price may have been the dominant source of real exchange rate movements during this period. Olomola and Adejumo (2006) investigate the relationship between the real oil prices and real exchange rate by including other important macroeconomic variables such as output, inflation, and the money supply, especially in Nigeria, in a cointegrated Vector Autoregressive (VAR) model. They examine the effect of an oil price shock on Nigeria’s currency against the US dollar exchange rate, output, inflation and the money supply. They find that an oil price shock does have a significant effect on the exchange rate as well as the money supply in the long run, but not on the output and inflation in Nigeria. Lizardo and Mollick (2010) use the same method to explore the oil price-exchange rate relationship. They consider the US dollar exchange rate against the currencies of oil-importing countries and oil- exporting countries, respectively; they also add the US relative money supply and relative industrial production into their cointegrated VAR model. They find that increases in real oil prices lead to a significant depreciation of the USD against net oil exporter currencies, such as Canada, Mexico, and Russia, but an appreciation against oil importers, such as Japan. Huang and Guo (2007) construct a structural VAR model to study the effects of oil price shocks, demand shocks, supply shocks and monetary shocks on China’s real exchange rate. They find that real oil price shocks would lead to a minor appreciation of the long-term real exchange rate due to China's lesser dependence on imported oil than its trading partners included in the RMB basket peg regime and rigorous government energy regulations. Narayan et al. (2008) use daily data on oil prices and the Fiji-US dollar exchange rate for the period 2000-2006, to study the links between the volatility of oil prices and the volatility of the Fiji-US dollar exchange rate, employing a GARCH model. They find that a rise in the oil price leads to an appreciation of the Fijian dollar vis-à-vis the US dollar. Most of the above literature also investigates the direction of causality between the price of oil and the US dollar exchange rate. All the above-mentioned empirical studies only find an effect of the price of oil on the exchange rate, but not vice versa, which is not consistent with the analytical consensus. Still, there is some research focusing on the effect of the exchange rate on the price of oil. Novotny (2012) investigates the effect of nominal effective exchange rate of the US dollar on the Brent oil price, by including the US dollar industrial production, short-term real interest rates, oil inventories and rate of use of oil refineries in the USA in the model. The findings provide evidence of an inverse relationship between the US dollar exchange rate and the Brent crude oil price, which may be due to the additional speculative demand for oil as an alternative investment instrument. Using cointegration tests and error correction models, Sadorsky (2000) investigates the relationships among futures prices for crude oil, heating oil, and unleaded gasoline, and the US dollar exchange rate. The results show a long-run equilibrium relationship between these four variables, and the causality is from exchange rate to those energy futures prices. Zhang et al. (2008) investigate the volatility spillover effect of the US exchange rate on the price of oil, using cointegration and ARCH-type models as well as the methodology of Granger causality in 342 The Links between the Price of Oil and the Value of US Dollar risk that is employed by Hong (2002) for risk effects. They mainly find that US dollar depreciation is a key factor in driving up the international crude oil price. In summary, most previous papers find a cointegrated long-term relationship between the price of oil and the US dollar exchange rate, with the causality running mostly from the price of oil to the exchange rate. In this paper, I pay attention mainly to the price of oil as a dependent variable, and study further the interaction between the spot price of oil and the US dollar exchange rate in the long term by employing a cointegration test and error-correction model, with consideration for possible structural breaks.
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