THE ROLE OF CRUDE OIL AND PETRODOLLARS

Crude oil and its derivative products fuel the engine of economic growth. As long as the
world is dependent on hydrocarbon-based energy, oil prices become a factor in stimulating
or delaying economic growth. Economic studies demonstrate that for every $10
per barrel rise in oil prices, real GDP in the United States is reduced by about 0.4 percent
economic growth (Federal Reserve Bank of St. Louis Review, November/December
2006, http://research.stlouisfed.org/publications/review/06/11/NovDec2006Review.pdf).
In the near term, higher oil prices result in reducing economic growth expectations
as well. Higher hydrocarbon prices portend increases in transportation costs and the perunit
cost of outputs in the economy, and therefore become an inflationary factor in the
costs of goods. More importantly, crude oil prices’ moving quickly higher disrupts anticipated
prices and further encourages fears of slowdowns. One of the most important aspects
of oil prices is that the market reaction to oil price increases often tends to overemphasize
its importance, particularly for the U.S. economy. Recent studies by the Federal
Reserve show that an oil price shock can be easily absorbed in the $14 trillion U.S. economy.
Recent research shows that “a 100 percent increase in the price of crude oil . . .
translates into only a 3.2 percent price increase in the typical basket of consumption
goods. Since unrefined oil is not a consumer good, the oil price shock is passed through
indirectly in the prices of many other goods and services” (Federal Reserve Bank of
Cleveland, November 2006, www.clevelandfed.org/research/commentary/2006/Nov.pdf).
A quick rise in oil prices, or even just the fear of a rise, offers trading opportunities.
Hurricane Katrina is a good example, as we saw some countries benefit from high
crude oil prices, while others did not. The result impacts currency prices as well. Closely
tracking oil is important in shaping currency-trading strategies. See Figure 3.1.
Oil has another impact. Oil-producing countries have amassed huge sums of money,
and what they do with their increasing petrodollars impacts currency values. The
International Monetary Fund (IMF) reported that the surplus of dollars to oil producers

amounts to $500 billion! The economies of Organization of Petroleum Exporting Countries
(OPEC) nations are accumulating current account surplus due to petrodollars that
are nearing 30 percent of their GDP! If oil producers start to shift into nondollar assets
such as the euro and pound sterling, the dollar fundamentally weakens. This has already
begun. The Financial Times reported on December 11, 2006, in a story titled “Oil Producers
Shun the Dollar,” that the Bank of International Settlement data showed a shift
into euro, yen, and sterling. OPEC and Russia data showed that the dollar holdings were
cut from 67 percent to 65 percent. Also, the report indicated a cut by Iran of US$4 billion
holdings and by Qatar of US$2.4 billion.
It was not a coincidence that the 2003 highs of the euro coincided with the last known
shift of oil producers from dollars to euros. It is also not a coincidence that the Canadian
dollar strengthens when oil prices increase and weakens when oil prices decline. We can
see that crude oil patterns have had wide ranges and are likely to continue to have such
swings. This will benefit the forex trader.


By ABE COFNAS