Oil Price Increase Due to Dollar Devaluation?
Posted by Max Dunn Sat, 12 Jul 2008 03:49:00 GMT
It is commonly thought that a large part of the increase in the price of oil is due to the devaluation of the dollar. For instance, since the the euro is now 60% higher than the dollar it seems to make sense that 60% of increase in the price of oil is due to this devaluation of the dollar. However when you look more closely at the economics behind oil pricing, you will find that this is not the case at all. Actually, it doesn’t make any difference what currency oil is priced in because the price would still be the same.
The reason for this is that the price of oil is based on simple worldwide supply and demand. If oil is too expensive in any currency, then producers would not be able to sell all they wanted. And if the price of oil were to low, then buyers worldwide would not be able to buy as much as they wanted.
Let’s look at a specific example. Today, oil traded at about $145 per barrel. Since the euro-dollar exchange rate is currently 1.6, that means that $145 is equal to 91 euros. So what is the fair price for a barrel of oil in euros? Would you guess 91 euros? And if oil had been priced in euros for the last 10 years, what would the price today be for a barrel of oil. Again, 91 euros and $145 dollars.
So it makes no difference what currency oil is priced in – the price would be the same. The fact that the dollar has devaluated against most other currencies makes no difference at all in the price of oil.
(Ref: The U.S. Dollar Hits an Oil Slick by Martin Feldstein is Professor of Economics at Harvard and President of the National Bureau for Economic Research.)