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Relevance of Oil Price in Forex Trading

In a globalized economy there is a strong interconnection between oil and financial markets, most notably that which involves currency markets. Therefore it would indeed be commonsense to figure out that there would be a net socio-economic gain if the price of oil falls. Obviously in such a situation economic growth is possible with lesser inflationary tendencies, as you could then have a period of lower interest rates which greatly helps to stimulate business.
In this article we will first try to analyze the reasons why the price of oil goes northwards or southwards as the case may be. Then we would try to figure out the relationship between oil prices and its possible impact on the value of currency pairs.

Effect of Oil Price on the Economy

The US Dollar is the currency in which oil is normally traded in international markets. Moreover it is an established fact that energy requirements of most industrialized countries are met from petroleum based resources. That makes oil a vital cog in the smooth functioning of any economy. A combination of these factors has a direct bearing on the consumer spending habits of the general population. For example, higher oil prices will negatively impact consumer spending. Why is that so? One of the reasons is that, higher oil prices results in higher cost of production of most consumer goods. Then again, higher oil prices would make the individual consumer pays a bit more for their daily requirement of automobile fuel and for fuel for heating their homes. This means that higher oil prices invariably results in an economic downturn in most countries in the world.
Sometimes the opposite could also happen. In other words, consider a situation wherein oil prices tend to be low. For example, more than a decade back oil prices averaged $20 or so. In fact in the summer of 1998, oil prices spiraled downward to a then 4-year low of $13. What caused this? The problem then was the recession in South East Asia coupled with the economic stagnation in Japan. As this region accounted for more than seventy percent of global oil demand, oil markets were naturally disrupted with negative demand. But then, lack of demand was not the only reason as to why oil prices tended to be low. Another compelling factor at that point in time was that, several countries in the world experienced milder winters possibly due to the El Nino effect. That meant lesser demand for oil to be used for heating purposes. Therefore oil exporting countries were left with larger stocks of oil than ever before. The net effect was a drop in oil prices.
Low oil prices have a direct bearing on the economies of some countries which are also oil producers. For example take the case of Nigeria, Mexico or Venezuela all of which are oil producing countries but nevertheless developing countries too. These countries have huge external debt that needs to be serviced from oil revenues. Therefore low oil prices could be detrimental to the economies of these countries.
On the other hand developing countries that do not produce oil are greatly benefited by lower oil prices. That is because they can then make substantial forex savings on importing oil at a lesser cost and at the same time access capital from developed countries at lesser interest rates. All this leads to a buoyant economy for non-oil producing developing countries particularly in Asia and Africa.

Effect of Oil Price on Currency Pairs

Now that you know the effect of high and low oil price on the economies of countries, you might be perhaps wondering why you should be worrying of oil especially in forex trading. After all you are not buying and selling oil in forex trading. However the fact remains that major currency pairs rise and fall with the price of oil. In other words, the price of oil is a leading indicator of currency price fluctuations. This scenario is least likely to change in the near future.
Why does this happen? Reasonably developed countries producing crude oil benefit from high oil prices as tremendous surplus funds are generated for their use. On the contrary oil importing countries benefit from lower oil prices and loose that advantage as oil prices go up.
So as the economy of the country gets strong, its currency naturally becomes dominant in the forex market and as the economic situation weakens the currency also weakens. This is the role between oil and relationship between oil and currency prices. Another important point is that, if the dollar were to appreciate then oil prices in real terms will rise in relation to the sterling and yen. Therefore low oil prices alone would not translate into income gains for European and Japanese consumers if the dollar were to appreciate.
Oil prices– where are they headed? Looking at recent oil prices it does seem that oil is definitely in an aggressive price mode. There doesn’t seem to be a reversal of the price trends in the near future at least not until the next Olympic Games is over. How do the price of oil and the currencies of countries correlate to each other?

Although there are several intertwined issues to be considered in answering this question, the following holds true.

a) Generally the currency of nations that produce and export oil will rise in value.

b) The currency of nations that import oil and depend on it for their exports will drop in relative value.

c) Most importantly profitable forex trades will involve a country that exports oil as against a country that depends on oil imports.

Let us consider some examples. For instance, consider the currency pair CADJPY. Sometimes people dealing in this pair land up with the most profitable trades. Why is that so? The answer lies in the fact that Canada produces oil in abundance and the mechanics of this oil production gives rise to a buoyant Canadian dollar. In simpler terms, Canada is the largest supplier of oil to the US and is fast gaining momentum as the largest supplier of oil to China also. This makes the Canadian dollar attractive from a trading perspective.
On the contrary, Japan imports almost all its oil requirements and that makes their economy sensitive to oil price fluctuations. What this means is that the price of Japanese exports will increase in tandem with oil price increases and that forebears a weakening of their position in international markets. So when the price of oil increases you could well expect a decrease in the value of yen.
Finally if you look at oil prices from an economic and historical perspective, you will be better prepared to gauge its relevance to currency prices. That is something which you gain in experience from actually trading in the forex markets.

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