Why Oil Prices are Important in Forex

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Previously we talked about how commodity prices and forex were more linked than meets the eye. The case of energy, as best illustrated by oil prices, deserves a closer look; and shows us how the market can react quite counterintuitively.

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The basics

To most traders, hearing that energy prices are important in forex makes perfect sense. Energy exports and imports are a major component of some economies, so if the price of oil goes up, those economies will do better, and their currencies will get stronger.

Canada, as the chief exporter of oil to the US, would likely rank high on the list of currencies affected by oil prices. Another would be the NOK, as their economy relies a lot on oil produced in the North Sea.

This is true, of course, but it’s also what most traders already know. In fact, you probably already knew that. So we’ve got to talk about what lies beyond that.

Energy prices in the economy

Likely, you are aware that energy prices have a major impact on transportation costs, as well as production costs. Everything we use requires energy to produce and transport. Higher energy costs inevitably have a negative impact on the economy, and lower costs help the economy. They also translate into inflation, as producers pass on the increased costs to consumers.

A quick view of that scenario might consider that while, for example, increased energy costs will increase inflation, this will have little effect on the currency pairs because higher energy prices will also affect other countries. Higher energy prices mean higher world inflation, and lower world economic growth, right?

Yeah, about that…

This doesn’t factor in the relative dependence on oil and other sources of energy from the individual countries (or economies, to talk discreetly by areas using a single currency, since it’s the relationship between the currencies that we are after). Because each country is different, the effect of energy costs doesn’t actually cancel itself out in currency pairs.

Let’s consider a scenario as an example; the price of oil goes up 20%. This will translate into an increase in inflation and slowing of the economy by a certain factor, say, 1% for a certain country. However, for another country that doesn’t use as much oil, for example, because it has a lot of hydropower and geothermal (and is famously covered in ice), this factor will be a lot smaller, say, 0.1%.

So even though oil is a commodity that is priced the same in both countries, because of their relative dependence on oil, it translates into more inflation for the first country, and less for the second – and consequently the currency pair between the two would end up appreciating in favor of the second.

The other factor to consider is discretionary spending. So that first country up there is highly dependant on oil – if oil is relatively cheap, it has “extra” money to spend on other things, such as luxury goods that it might buy from a certain country with a lot of mountains and excellent chocolate.

If the price of fuel were to go up, you might expect that first country’s currency to depreciate, as it starts to be impacted by inflation – but that doesn’t necessarily mean that it will lose value relative to that second country. With the economy slowing due to higher oil prices, that oil-dependent country might buy fewer luxury goods, dropping demand for the second country’s currency. The end result is that the currency pair actually goes the opposite direction.

Now, it’s true that arbitrage can counter the effect if the countries in question are relatively small. But if it’s a major economy that’s involved, then the sheer size in the change of demand will overcome the arbitrage effect.

Of course, you (likely) won’t see this playing out in a day – these are usually more long-term moves. But keeping an eye on energy prices might give you some insight into long-term currency trends.

Take Europe, for example, which imports a significant amount of oil. Europe does produce oil, yes – but in the North Sea, chiefly, which is outside the Eurozone. So, increased oil prices mean that more euros are being spent on buying fuel, putting pressure on the Euro. Maybe not enough to move the euro in line with Brent prices – but oil above $100 a barrel will certainly put more downward pressure on the Euro than oil at $50 a barrel.

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