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To lower oil price, boost the buck?

The weak dollar may push up energy prices by affecting supply, demand, and investor behavior.

By Staff writer of The Christian Science Monitor / June 27, 2008

For six years, the world has witnessed an intriguing phenomenon: Oil prices have soared as the US dollar has declined in value.

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Now some economists say the simplest way to ease oil prices in the short term is to boost the value of the greenback.

It's a controversial idea. Clearly, oil prices are driven mainly by the fundamental trends of oil supply and demand. And even if an oil-dollar link does exist, economists say it's not clear that the dollar's downward trend can – or should – be reversed. Some say a weaker dollar is needed to help reverse America's large trade imbalance over time.

Still, with oil prices near record levels, concern about the dollar's dive is getting more attention.

"Increase the value of the dollar and lower the value of the euro. That by itself will lower [oil] prices, assuming all other things being equal," says A.F. Alhajji, an energy economist at Ohio Northern University in Ada. Beyond that, he says, the world will basically need to wait for market forces to adjust supply and demand.

If a steadier dollar would help, one positive sign is that the greenback has firmed up a bit in the past three months. But it's not clear how much it would need to rise – or how long it would take after that – to influence oil prices.

Algerian Energy Minister Chakib Khelil, the current president of the Organization of Petroleum Exporting Countries, said Thursday that the dollar is playing a major role in oil prices, and offered a hard estimate, according to a report by Marketwatch. At a meeting in Paris, he said a drop of 1 to 2 percent in the dollar versus the euro could add another $8 a barrel to oil prices.

The dollar-oil issue also came up Wednesday in a congressional hearing on whether high fuel prices are a bubble or a "new reality."

"While the correlation does not hold week in and week out, we believe that this trend – a falling dollar contributing to higher oil prices – is very strong," Daniel Yergin of Cambridge Energy Research Associates told senators.

Economists who see a dollar-to-oil link say it's operating through several channels, some long term and some short term:

A supply effect: The fact that oil is priced in a single currency worldwide – the US dollar – has significant effects on companies and nations that produce oil, Professor Alhajji says.

A rising price of oil has clearly brought billions in extra profits. But since the dollars that producers receive have gone down in value, that windfall has been partially offset.

As a result, he says, the oil-rich nations have probably been investing less in new oil production than they would have under a stable dollar.

Some analysts cast the impact on oil production in investment terms: If a nation's immediate economic needs are being met, why swap an asset that's rising in value (oil reserves) for one that's falling (dollars)?

A demand effect: Oil prices have been rising for consumers around the world. But this, too, has been partially offset in many nations by changes in currency rates. Europeans are buying more oil than they would if the US dollar were their currency.

"Because the dollar can't fall against the [government-managed] Asian currencies, it falls too much against the euro," says Peter Morici, an economist at the University of Maryland in College Park. "That gives Europeans more" to spend on oil.