Why You Can Blame the Dollar for Higher Oil Prices Last Week

By Markets Fool.com

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The price of a barrel of oil changes depending on what currency you're buying it with.

Crude oil prices rose last week for the first time in more than a month, with West Texas Intermediate ending up nearly $2 on Friday, to $45.87 per barrel. But rising prices weren't the result of falling production, rising demand, or even shrinking inventory, which might show some fundamental strength in the oil market. Instead, it was the dollar that drove the price of oil higher in a frenzy of trading last week.

The dollar and oil prices may have more in common than you think. As you can see below, the drop in oil prices during the past six months has coincided with a rise in the dollar, which is no coincidence. What ties the two together explains a lot about the big fluctuations in prices last week.

^DXY Chart

^DXY data by YCharts.

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Tied at the hip
The price of oil and the dollar are really tied at the hip because the dollar is the currency in which most oil is traded. If the dollar rises in value, it makes the price of oil seem lower. If the dollar falls in value, like it did last week, the price of oil will rise as a result.

To show how this works, let's look at an example of exchange rates. Let's say we're importing a barrel of oil from Canada -- which happens to be the largest exporter of oil to the U.S. -- and the standard price of oil is $50. If the U.S. dollar to Canadian Dollar exchange rate changes by 10% higher or lower, the effective price of oil in Canadian Dollars doesn't change; but the price in U.S. dollars swings dramatically.

Dollar Strength

Exchange Rate

Price in U.S. Dollars

Price in Canadian Dollars

Parity

1 U.S. Dollar = 1 Canadian Dollar

$50

$50

Weak Dollar

1 U.S. Dollar = 0.9 Canadian Dollar

$55.56

$50

Strong Dollar

1 U.S. Dollar = 1.1 Canadian Dollar

$45.45

$50

Calculations by the author.

There's the same effect in oil markets, which are priced in dollars, but where a majority of the world's oil is consumed outside of the U.S. As the dollar fluctuates, it can swing the price of oil wildly within the U.S.; but if you're in Canada or Saudi Arabia, you may not see the same impact on your local currency.

This is essentially what happened last week with oil prices. The dollar plunged in value after the Federal Reserve concluded its policy meeting, and that had the effect of raising oil prices for the week. None of this changes the fundamental oversupply in the oil market, which has caused prices to drop more than 50% since last summer. Both short and long term, however, the relative strength or weakness of the dollar has a big impact on oil prices.

Ying and yang of the strong dollar
From within the U.S., movements of the dollar can have either a positive or negative impact in energy markets, depending on where you sit. Clearly, a strong dollar and resulting lower oil prices are good for consumers, who are saving hundreds this year at the pump.

But the same dynamic cuts the opposite direction for oil explorers in the U.S. Shale giants like Continental Resources , Whiting Petroleum , and SandRidge Energy are seeing lower sale prices for their oil and no change in costs because they're domestic producers. If the dollar continues to strengthen, they'll be put under even more financial pressure, and may have to sell assets, or look for a buyer for their companies just to stay alive in this market.

Currency fluctuations may have a bigger impact on energy markets than you think, and last week was just a small example of that. Long term, the industry needs to see supply come more in line with demand for oil prices to rise; but a strong dollar doesn't help the financial situation of U.S. companies, either. The bad news is that currency moves are entirely out of the industry's control.

The article Why You Can Blame the Dollar for Higher Oil Prices Last Week originally appeared on Fool.com.

Travis Hoium has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.