Do Oil Prices Still Power International Currency Values?

Do oil prices still power currency values?

The answer – which is a very definite yes – may surprise you, as it did the currency trading community in December 2014 and January 2015, when oil prices plunged on OPEC’s decision not to cut supply.

The markets were caught napping, having become accustomed to oil prices gently rising and falling within the range of $90-$110 per barrel, a level to which they had risen some years earlier on supply fears.

Jolted awake by the downward spiral in oil, markets around the world saw the USD and its pegged Gulf currencies rise, the Ruble fall, the Euro crumble, and the CAD tumble.

The connection between oil prices and currency values is complex, but boils down to a simple rule – oil-producing countries rely heavily on the income from energy sales; this income translates into economic power and therefore adds to or subtracts from the country’s currency value.

The recent oil price crash comes down to basic supply and demand rules; the market perceives an oversupply and the price drops.

So the questions are; how long will the price remain relatively low, and what could trigger its rise?

The answers could lie in OPEC’s decisions in the first quarter of 2015. So far, the main oil-producing countries of the UAE and Saudi Arabia seem content to let the current situation continue.

Such a dramatic drop in the price of oil has surprised many, however OPEC’s decision not to cut production in November just confirmed a bearish longer-term outlook for the commodity.

Since November (same month as the OPEC decision), the price of Crude has tumbled from $70 to below $50, while Brent has spiralled down from around $77 to $50. In January, this decline continued to below $50.

There is a complete over supply of oil production and repeated global economic concerns are elevating fears that there will be reduced demand for oil moving forward, which is inspiring further selling.

Some are still anticipating oil prices bouncing back, but it appears that there could be a long wait before any reversal. Despite the oil prices falling at what some see as an alarming rate, there is a simple supply and demand equation to be answered here and the only answer has been further weakness in the price of oil.

Until the oil markets find a floor and optimism rises in the global economy, meaning there could be increased demand for oil – I can’t see any recovery on the horizon with these current economic conditions.

So what does this mean for powerful oil-producing nations such as the UAE and Saudi Arabia?

We have seen losses in the stock markets around these regions, so the dive in prices is certainly weighing on investor sentiment. Other than that, it is quite tough to predict what the economic impact for Gulf nations like the UAE and Saudi Arabia will really be.

Reason being, these economies are far more diversified away from oil trade reliance than some realise and I do think this has something to do with why neither nation has appeared spooked by the decline in oil prices.

Other economies such as Venezuela and Russia are very much centralised on the oil sectors, while some Gulf nations have built up domestic momentum in tourism/services industries.

The question continues to be floating around regarding whether/when OPEC will cut production and to be honest, I am unsure whether they will.

The economic conditions for the industry as a whole have changed in recent years, with inventories increasing in areas outside of the OPEC group; the decision not to cut production back in November was basically seen as an unconfirmed admittance that OPEC is not in control of the price of oil as much as it used to be.

If OPEC do decide to step in and cut production, they could potentially be waiting for the price to bottom and revenues to become stretched, before possibly stepping in.

So, are we looking at another historical oil price crash?

It’s shaping up that way, because traders are becoming increasingly aware of the over-powering supply and demand equation that is just inspiring further selling. OPEC’s laissez-faire attitude towards the plummet in price so far has not helped the chances of a meaningful recovery either.

What we have noticed over the past week though, is a small rebound back towards the $50 area with this being inspired by suspicions that oil producers might be considering reducing production levels.

This bounce shows investors are still interested in purchasing the commodity however less production has to actually be noticed, otherwise the commodity will still face downside risks.

And finally, will the international currencies continue to see volatility in early 2015?

“Yes, we can expect continued volatility on the currency markets. Even economies who are not reliant on oil production are encountering unexpected deflation risks, which has emerged as a concern for several central banks.

The Bank of England (BoE) is the greatest example of this because the unexpected deflation risk following the collapse in the price of oil has completely eliminated any optimism that the BoE will raise UK interest rates this year.

This has been a major contributor behind the GBPUSD falling from 1.55 to 1.49 in January. The added deflation risks to the Eurozone was also probably a major catalyst behind the European Central Bank (ECB) finally giving in to calls to introduce QE last month.

Other pairs where an economy is directly impacted by the decline in oil prices will be interesting to watch as well, such as the USDRUB, USDCAD and USDNOK pairs.

So far the movement in these pairs has been due to speculation on how an economy might be weakened by the lower prices, but it is not until economic data starts to come through that this can really be explored