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Thursday, May 15, 2008

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Oil prices and the dollar have made the news lately. Oil prices have risen, while the dollar has simultaneously plummeted against the euro. We can measure how much these two prices move in tandem, using a correlation coefficient. This measure takes on the value of zero if there is no correlation, the value of one if there is perfect correlation, i.e. every time one price goes up the other one does, too, and the value of minus one if there is perfect negative correlation, i.e. every time one price goes up, the other goes down. The correlation coefficient between oil and dollar is -0.7. That is, most of the time, when the dollar fell against the euro, oil prices rose.

Because oil prices and the dollar have moved in opposite directions, the increase of oil expressed in euros instead of dollars has been less pronounced than the oil price increase in dollars. This may not be coincidental. Oil producers sell their products in dollars. These dollars are used to purchase other goods in international markets. As the dollar lost its value starting in 2002, oil producers could afford to buy less in international markets with their dollars. To compensate for this loss of buying power, they may have raised the dollar price for oil. As a result, while oil prices in dollars rose by 162 percent from their low point in January 2002, they climbed by less than half that rate measured in euros, 77 percent. At that rate, oil prices would have only risen to $34 per barrel in October 2004, instead of the actual $52, without changes in the dollar’s value.


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