Just as it is possible to use crude oil’s market movements to identify macroeconomic trends, this information can be useful in trading currencies and other kinds of financial assets that are related to oil. 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.
Many countries around the world such as Mexico and Saudi Arabia heavily depend upon their oil exports, especially in terms of budgeting and their country’s overall economic performance. Crude oil is an essential commodity for the functioning of the modern world, so an increase in the oil price is often related to inflation, economic growth and the price of other goods, especially the prices, and therefore the demand, of products made of petroleum.
Crude oil’s market movements are highly relevant for oil and petroleum producing economies, not only in terms of policymaking but also in terms of forecasting the local economic performance. This is also true for the rest of the world, since it’s impossible to imagine our current economic system without the black gold, therefore that information may be useful in forming our expectations regarding inflation and other macroeconomic factors.
Crude Oil Price Movements and Exchange Rates
We already mentioned that there are countries that are heavily dependent on their oil exports. This fact is important not only because a bad year in the oil markets could affect the economic performance of these countries, but because oil prices and quantity fluctuations usually affect the exchange rate of those countries.
Let's take Canada as an example. Like many other countries, Canada is heavily dependent on its exports to the rest of the world, but as one of the main oil producers in the world, it shouldn't be surprising that crude oil is the main source of Canada’s total foreign exchange earnings, especially because crude oil is priced and traded in U.S. dollars.
In other words, an increase in the crude oil price (assuming a steady demand) often means an increase in the U.S. dollar supply in the Canadian economy. This usually pushes the exchange rate downwards, since Canadian dollars would be now relatively more scarce compared to the number of greenbacks that are now circulating in the economy. The reverse, of course, is also true: falling oil prices mean that Canada will be getting fewer dollars per barrel, which implies a lower U.S. dollar supply in the economy and an increase in the exchange rate, given the relatively scarcer US dollar.
As a trader, there are ways of taking advantage of oil price movements by means of trading crude oil currency pairs, especially if you are reluctant or unable to trade crude oil directly.
One “oil pair” in Forex is the USD/CAD, as the Canadian Dollar is the biggest proxy for crude oil in the global Forex market. This pair tends to increase in value when the oil market is down, and it decreases in value when the market soars, which means that it may be possible to formulate a strategy to trade this pair based on the oil market price movements.
Other currencies benefit from a positive correlation with crude oil, like the Norwegian Krone and the Russian Ruble; however, those tend to have a low liquidity, which means it may be harder to take advantage of the relationship between these currencies and crude oil, at least compared to other Forex correlations. This means that trading oil currency pairs like the USD/NOK or the USD/RUB may be harder, at least compared to other “oil pairs” in Forex that tend to be more liquid, like the USD/MXN or USD/CAD.
Regarding crude oil prices and the U.S. dollar’s value relative to other currencies, there used to be an inverse relationship between them, but that fact has changed over time. The inverse relationship was especially true when the United States was considered a net oil importer, but the situation has changed significantly in the last decade, as the U.S. became an important oil supplier and an important influence over global crude oil prices. Now the correlation tends to be positive, though it must be remarked that this has been anything but constant over time.
Crude Oil Price Movements and Fundamental Analysis
Just as crude oil prices can influence currency exchange rates, they can also impact the fundamentals that play a role in the valuation of some currencies.
As we said, there are countries that are heavily dependent on their oil exports, for example, Mexico, Norway, and Venezuela. Because of this, unfavorable oil price movements affect traders' and investors' perceptions about the intrinsic value of their currencies. For this reason, it shouldn’t be surprising to see traders running from currencies like the Mexican peso towards “safer assets” when oil prices collapse.
The inverse is also true. Rising oil prices could favor certain currencies. For example, due to Mexico’s vast oil reserves, positive crude oil price movements tend to favor the performance of the Mexican peso.
Naturally, this correlation is not perfect, especially because there are other factors that could impact the fundamental assessment of any given currency, independently of the country’s reliance on the oil markets.
An example of this, at least over the long run, is the performance of the Norwegian Krone. As we already know, Norway is a large energy producer as oil accounts for about 62% of its exports. Nevertheless, the correlation of this currency with the price of crude oil is very volatile and tends to be lower when the oil markets rally. This fact has made some analysts think that despite positive price movements favoring Norway’s economy, the relationship between the Norwegian Krone performance and the price of Brent crude oil from the neighboring North Sea is not very clear.
In any case, there seems to exist a more solid correlation when the price of crude oil is falling, so it may be possible to profit from this positive Forex correlation when the oil market crashes.
Crude Oil and Other Assets
Just as it is possible to trade Forex currency pairs based on crude oil price movements, traders can also take advantage of the relationship between oil market movements and other assets, particularly other commodities.
There is, for example, a well-known correlation (though not statistically constant) between the price of crude oil and the price of gold. As an essential commodity, increasing crude oil prices usually increase inflation pressures across the world, so when oil prices rally this tends to push up inflation over the long run.
Gold is a well-known hedge against inflation, so it shouldn’t be surprising to see traders running towards this precious metal when they fear the continuous depreciation of the main global currencies. Silver and other precious metals tend to be highly positively correlated with gold, so there may be a chance to take advantage of other Forex correlations.
On the other hand, falling oil prices tend to exert a downward pressure on inflationary trends, which tends to hinder optimism about U.S. treasury yields.
Oil prices are also a huge influence in terms of the world’s economic performance, so when crude oil prices rise by too much this tends to hinder economic growth, making traders run towards alternative assets like gold.
The gold supply chains themselves are also heavily influenced by whatever happens in the oil markets. Oil is extensively used in gold mining, so increasing oil prices tend to affect the margins of gold mines, affecting the supply of the metal.
Another asset that has a well-known, though tricky, relationship with crude oil is natural gas. Historically, both commodities have moved in tandem as they were often positively correlated, however, this relationship has changed significantly in the last decade.
Crude Oil Prices and the Forex Market: Trading Opportunities
Sharp market movements may be an opportunity to trade currencies and other financial assets that have a positive (or even negative) crude oil correlation.
This means that a stock market crash may present an opportunity to short energy stocks, or to be long on popular crude oil forex pairs like the USD/CAD and safe haven assets like gold.
Conversely, a positive outlook for the stock market may be an opportunity to short crude oil Forex pairs, or to be long on commodities which tend to be positive correlated with the price of crude oil.