With the Oil price hitting new high of $82 per barrel last month the focus is again on the impact of dollar weakness on oil prices. Last month also saw the US dollar falling to new lows against basket of currencies. So how is that the dollar weakness causes high oil prices.

Theoretically oil prices are determined by three factors:

• Current supply in terms of output, especially the production quota set by OPEC.
• Oil reserves, including what is available in U.S. refineries and what is stored at the Strategic Petroleum Reserves.
• Oil demand, particularly from the U.S. (as estimated by the Energy Information Agency)

Take for instance country X that receives say $75 a barrel for oil from all countries of the world. This $75 is then used by country X to buy goods and services from other countries. With no inflation around, the income of country X in US dollar is unchanged. However with the fall in the value of dollar the income of country X in its currency or in the currency of its trading partners has decreased. Also other countries whose currencies have appreciated are enjoying a discount on their oil with the fall in the value of dollar. This discount can only be removed by letting the $ price of oil to rise to compensate for the fall in the $. Also maintenance of the same purchasing power in the domestic currency mandates an increase in oil price in $ terms. Thus decline in dollar’s value results in oil prices in dollar terms.

Theoretically, dollar devaluation also reduces drilling activities in oil producing countries. All other things being equal with dollar depreciating these countries purchasing power is reduced fuelling domestic inflation levels. Dollar devaluation by making oil cheaper in other currencies increases demand for oil in countries with non-dollar appreciating currencies. Regardless of OPEC decisions, dollar devaluation on its own tightens supplies, increases demand and keep oil prices high for an extended period of time.

Oil prices have increased only in dollar terms. In other currencies the increase in oil prices is not so steep. So why price oil in dollar. Oil is entirely global so why not accept different currencies from different countries? These are questions which are being raised by many emerging economies like Russia, China and Brazil. Recently Russia and China have agreed major oil and gas deals that may well be priced in either the Rouble or the Yuan. Iran is also trying to price its oil in euro terms. This move will further devalue dollar. With the fall in the use of the U.S. $ in the oil market, the excess dollar held in central bank reserves of various countries will be released into other markets which would be unable to absorb them.   If this practice were to continue and other oil producers accepted currencies other than the U.S.$ more dollars would flow into the foreign exchange markets of the world, where they will prove too much and the $ will further fall relative to other currencies.