Greece’s sovereign debt default obviously affects banks and finance ministries.  A casual observer might not expect Greece’s debt crisis to have anything to do with global oil prices. Greece does not have an important role in the global oil market aside from its shipping companies, which are hardly affected by the government debt crisis.

Yet after the default, news outlets reported versions of the following :

“ICE Brent crude oil prices are trading nearly three percent lower as Greece debt worries bring European stocks sharply down.”

Or

“The weak dollar is the biggest driver of crude prices this morning and hopes of a financial rescue for Greece are propping up sentiments.”

What underlies these enigmatic – if confidently assumed – connections?  We can use this particular example of the link between Greece’s economic woes and oil prices to better understand how inextricably oil is interwoven into the global political and economic fabric. Unlike other widely traded commodities, such as soybeans or diamonds, nearly every major world event, from conflict to natural disaster to GDP growth rate changes impacts the price of oil, which we then feel almost instantly at the pump as we try to get to work or take the kids to school.

What happened is as follows: European governments, led by Germany, drafted a financial bailout plan for Greece. As a result of this good news, the Euro rose from a historic low caused by the troubles of Greece and other EU members, and European stocks rose in tandem. This forced a weakening of the dollar. Higher stock prices + Weakening Dollar = Rising Crude Prices.

It is fairly indisputable that there is a correlation between the dollar and the price of a barrel of oil. For most of 2009, oil prices rose whenever the dollar weakened.  However, it may be mistaken to always treat it as a causal line, as reported in October 2007 by the UK Times:

“Dollar weakness has boosted the price of dollar-denominated commodities and helped oil to surge by more than a third since the middle of August.”

Global oil prices are denominated in dollars, so when the dollar falls against another currency, like the Euro, oil becomes “more expensive” from the perspective of those of us at American pumps – it is worth more nominal dollars.

Stock prices are also often invoked as a reason for oil prices going up or down. Traditionally, high oil prices meant higher costs for businesses and pushed down stock prices. Therefore, oil prices were inversely related to stock market movements. Investors put their money into oil (and precious metals like gold) both to hedge against dollar and stock market risk. In recent years, there has been an unprecedented increase in speculative commodity investment.  More recently, the relationship has been closely positive: that is, when stock prices go up, so do oil prices. This may be because investors see higher stock prices as indicative of higher future oil demand.

The relationship between the dollar and oil prices is, in fact, more complicated than simple causation. Instead, there is at least some degree of two-way causality. When the price of oil goes up, countries (including the U.S.) have to import more oil, which hurts our current account and terms of trade. That should weaken the exchange rate. The more we import, the weaker the dollar. Even further, higher oil prices hurt our economy, and when an economy weakens, its currency usually depreciates.

Another complicating factor is the effect of the real interest rate, or monetary policy. As the real interest rate declines, commodity prices tend to go up. Investors can’t get as much return on their money if they lend it out, so they put it into commodities like oil instead. Expectations about inflation also affect oil prices. If investors don’t believe the Fed can contain inflation, they are likely to put their money into oil. All of this means that oil volatility is a function not only of physical demand and supply, but of monetary policy.

These somewhat arcane issues highlight the important reality of oil dependence in an environment of increased speculation. By importing such massive quantities of oil, we bring down the value of the dollar, weaken our terms of trade, and leave ourselves vulnerable to volatility that springs from many sources beyond physical supply risks and demand pressures, including global stock markets and international monetary policy.

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