"Dollar Falls as Oil Goes Up"

is a typical financial news headline these days. Bloomberg just ran an article that stated exactly this

The dollar posted its third consecutive weekly decline against the euro as the U.S. housing slump and record oil prices slow growth in the world's biggest economy.

The dollar fell against 13 of the 16 most-traded currencies this week as oil touched a record $135.09 a barrel yesterday on the New York Mercantile Exchange. The U.S. is the world's biggest importer of oil. Oil traded at $131.87 today.

The correlation coefficient between oil prices and the euro dollar exchange rate has been 0.95 for the past year, indicating they have moved in the same direction 95 percent of the time.

First of all, the statistical correlation between euro and oil price implies absolutely nothing about the causality between oil and dollar. Both euro and oil are priced in dollar term, so if the dollar depreciates against everything else (euro, sterling, yen, gold, and oil), you'd precisely expect a positive correlation between euro and oil. In fact, the closer the correlation is to 1, the more likely that we're having an exogenous shock that comes from the dollar factors, and not the oil factors or the european factors.

This accounting correlation is masking what's going on underneath. There's probably a real but complex causal mechanism between oil, dollar, euro and everything else, but it will not be easily identified by just looking at the simple correlation or multiple plots.

At the very least, if we were to test the hypothesis that an increase in oil price is bad for dollar, then we are looking for a relationship between the oil price in effective terms, and the dollar in effective term (say some trade-weighted index). To the best of my knowledge, such strong and systematic statistical relationship cannot be found, and there's no compelling reason why it should be found. US is the world's biggest importer of oil, yes, but that's an absolute measure, plus the energy use efficiency needs to be taken into account. And should the Asian countries stop subsidising their oil prices (as Stephen Jen at Morgan Stanley recently wrote they might have to soon), no doubt you'll see that US is by no means the most vulnerable to oil price shock.

Incidentally, on exactly the same day, Chicago Tribunal ran the headline "Dollar's Drop Fuels Oil Rise". Know what I'm saying?

Oil Price: Is It a Bubble?

Charles Engel reckons it's a real possibility, and has this to say

Economics is an inexact enough science that we can’t know whether $125, or $60, or $200 is the right price based on fundamentals. I don’t know one way or the other what the right price of oil is, but what I don’t understand is the steady increase in the price of oil. How can an asset such as oil consistently pay such a high return?

One possible explanation is that the market has kept learning about the strength of demand and the weakness of supply over the years. It is consistently being surprised, in other words. That may be right, but it is a shaky argument: why is the market always being surprised in the same direction – that excess demand is greater than we thought?

Another story that I think makes some sense is the one that Jeffrey Frankel and Jim Hamilton have promoted – that Fed monetary policy has played a role. As I noted at the outset, a drop in real interest rates should cause commodity prices to rise. But here again, the decline would also have to be unanticipated to explain the continual increase in the price.

I think there is a lot of truth to the view that markets keep getting surprised in the direction that makes oil prices higher. We have been surprised at the growth in emerging markets, the shortfall in supply from some countries (such as Iraq), and the continuing low real interest rates. On the other hand, it seems to me that rising prices are also typical of frothy markets (like the housing market of late.) In fact, the steep rate of increase could even be a “rational bubble”. The rate of increase of the price is so high, perhaps, because the market is incorporating a probability of the bubble popping and prices falling back down to earth.

In a rational bubble, the oil price is rising, but there is some probability that the bubble will burst. Let r be the real interest rate. Let p(t) be the log of the real price of oil at year t, pfun(t) be the fundamental long-run price (after the bubble pops), and let k be the probability of the bubble popping. To keep it simple, I’ll assume r and k are constant. Then the expected rate of increase in the real price of oil should equal r:

r = (1-k)(p(t+1)-p(t)) -k(p(t)-pfun(t)).

(For those who aren’t familiar with logs, p(t+1)-p(t) is approximately the percentage increase in the price of oil, and p(t)-pfun(t) is approximately the amount by which oil is “over-priced” in percentage terms. The “expected rate of growth” of the oil price is simply the weighted average of the growth rate of the price if the bubble persists and the percentage decline expected if the bubble bursts. The weights are given by the probability of the bubble persisting or popping.)

So, as long as the bubble has not popped, you will see

p(t+1)-p(t) = [r+k(p(t)-pfun(t))]/(1-k).

The percentage rate of increase in the price exceeds the real interest rate. Indeed, you can see that the growth rate in oil prices would have to rise as the price rose (as p(t)-pfun(t) gets larger.) That is, the price would accelerate until the bubble burst.

In this type of rational bubble, the futures price would indicate an “expected” increase in the price equal to r, the real interest rate. But until the bubble burst, the actual increase in the price would always exceed the real interest rate. So the futures price would always underpredict the actual increase in the price of oil, much like it has in fact over the past four or five years. The payback to speculators betting against oil only comes when the bubble finally bursts.

From the perspective of producers, there is no difference between this and the no-bubble case (assuming that the producers care only about their expected return.) If they “hoard”, they expect the price to rise at the rate r, and if they sell now they can take the proceeds and earn r. They are indifferent between selling now and hoarding. There is no excess supply. Producers pump out of the ground exactly what people will buy at price p(t). The level of the price in this case is determined just as in the no bubble case – the sum of the expected demands in every period equals the amount of oil in the ground.

A bubble in asset prices need not be “rational”. But if the run-up in prices were too rapid, so that the “expected” growth rate of the price exceeded the interest rate, there would be a strong disincentive to sell any oil. Producers would want to keep the oil in the ground, and, as Paul Krugman has argued, speculators would have an incentive to hoard oil. We see very little of that type of behavior going on, as Krugman has noted.

The problem for economists is that the market for oil is so complicated that we cannot very accurately calculate what the price of oil “should be” if there is no bubble. We have to read the entrails to figure out whether the price is really reflecting market fundamentals – demand, supply, real interest rates – or has a bubble component. As I look at the rising price, I wonder which story is most plausible: (1) the markets have been surprised over and over about demand by end users and production capabilities; (2) markets have been surprised over and over about how low real interest rates are; (3) there is a bubble. These stories may go together, in fact. Indeed, it is hard to see how a bubble could get started all by itself, or how it could go on for a long time before it popped. In the previous asset price bubbles I mentioned above, it seems as though fundamental economic causes set off the rise in asset prices. But it looks like the bubble traders were inspired by the price increases to bet on further increases in prices, even when there was little evidence that the price needed to rise more based on fundamentals. It’s as if the fundamental traders normally keep the bubble traders at bay. But a series of shocks to the fundamentals in the same direction seem to undermine the confidence of the fundamental traders and give the bubble traders the upper hand. In any case, if either (2) or (3) are true, we might see oil prices coming down in the future, as real interest rates return to more historic levels, or as the bubble bursts.