Oil prices and forex rates share an intimate relationship; this correlation exists due to many factors, such as balance of trade, supply chain patterns and market psychology. Crude oil is an important source of energy, and fluctuations in its price affect the global economy. The currency exchange rate becomes one of the important channels through which international oil price shocks are passed on to the financial markets and the real economy. This is particularly true for major oil importing and exporting nations. Many of the world’s major forex pairs depreciate or appreciate based on oil price fluctuations.

In this article we explain how understanding oil price movements can be useful for a Forex trader, as we examine the relationship between the crude oil and Forex markets. We’ll also explain why paying attention to crude oil prices could be useful in terms of formulating a successful foreign exchange trading strategy.

Oil-Producing Economies and Currency Prices

One of the most apparent correlations between currency prices and oil can be seen in countries that produce and export oil as a major component of their economies. Such countries are naturally very dependent on high oil prices, meaning that a collapse can have the effect of eroding the value of their national currency.

When explaining what is forex trading and how does it work, it is important to bear in mind that the value of currency pairs is largely based on the economic performance and standing of the countries involved. Currency traders will often look at national economic developments to predict a correlating fall or rise in the value of currency pairs.

When a country that is heavily dependent on oil exports, such as Russia or Saudi Arabia, experiences a collapse in oil prices, a correlating collapse in the value of their national currency, compared to currencies such as the US Dollar, nearly always follows. When oil prices are high, such countries often experience a rise in the value of their own currencies; which can be both a good and a bad thing.

Oil and the U.S. Dollar

The United States of America is the largest producer and exporter of oil in the world, so it makes sense that the US dollar would be impacted by global oil prices. However, the US economy is not very dependent on oil exports, which actually only makes up a small percentage of GDP.

Crude oil is quoted in U.S. dollars (USD). So, each uptick and downtick in the dollar or in the price of the commodity generates an immediate realignment between the greenback and numerous forex crosses. These movements are less correlated in nations without significant crude oil reserves, like Japan, and more correlated in nations that have significant reserves like Canada, Russia, and Brazil.

When the value of the dollar is high relative to other currencies such as the Euro and the Japanese Yen, you need fewer US dollars to pay for a barrel of crude. However, when the value of the dollar is low, more dollars are needed to pay for that same barrel.

While this is good news for the US, it can be bad news for countries that are net importers of oil, such as Japan or the UK. Such countries can find themselves paying more for oil depending on the fortunes of the US dollar. Although some have argued that the US dollar’s strong impact on the cost of oil is now loosening, it is still a vital consideration in energy markets around the world.

There is no denying that oil remains the world’s most important commodity for a number of reasons. The close correlation between crude prices and currency values will continue to shape economic trends for decades to come.

Other Currencies that Fluctuates with Oil Price

Apart from the United States, other major economies, like Canada and Russia, are dependent on the oil export-import balance. Given that oil trades form a major portion of their countries’ GDP, their currencies are significantly impacted by oil price fluctuations. These are sometimes called “petrocurrencies.”

Canadian Loonie (CAD/USD)

As of March 2019, Canada is the 7^th largest oil producer in the world. It has a significant energy trading relationship with the United States, and is, in fact, the country’s largest oil supplier. Over 16% of US oil imports come from Canada. This shows how exposed the forex pair is to oil prices. In August 2015, the pair declined to an 11-year low due to a global decline in oil prices.

Norwegian Krone (USD/NOK)

Norway’s petroleum sector is an important part of its economy. It is not only a source of export revenue but also a source of finance for the Norwegian welfare state. In 2014-15, when prices reduced dramatically, NOK depreciated against the USD by 23%. From 2016 to 2018, NOK gained 13% against the USD, when prices started climbing.

Russian Ruble (USD/RUB)

Russia is the third largest oil producer in the world, with a production rate of 10,800,000 barrels per day. Oil exports constitute almost 50% of its export revenue. The country’s heavy reliance on oil and petroleum exports has been a reason for its economic decline in the past. On June 19, 2014, the Russian Ruble fell about 49.05% against the USD, when the Brent Crude price fell 49%.

The Brazilian Real and the Columbian Peso are other examples of petrocurrencies.

Does Exchange Rate Have a Say in Oil Price?

Fluctuations in forex rates don’t change the supply and demand fundamentals of oil. If the US Dollar falls against the Japanese Yen, then the US citizen’s consumption power is reduced in the same proportion to the gain of a Japanese citizen. Demand gets reallocated, but not changed.

There are somewhat monopolistic forces in the oil market. OPEC acts as a price setter, as do Saudi Arabia and US shale oil producers. When oil price is set lower in US Dollars, it means that $1 buys more oil. The Dollar’s forex value increases in real exchange rate terms. The forex market adjusts itself to the new changes. This means that while oil prices set by monopolistic agencies affect forex rates, the reverse is not true.

Traders should keep note that currency exchange rates are impacted by many other factors like political tensions, monetary policies and natural disasters. There are other issues and events that impact the oil markets as well. Many studies that aim to show the correlation between the two markets do not rein in the supply-demand aspect as well.

All in all, it is evident that oil price shocks result in exchange rate pressure for exporter nations. These countries counter such pressure by increasing or decreasing foreign reserves holdings.