To lower oil price, boost the buck?

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

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.

A different effect is at work in China, which he says has been holding its currency artificially low as a way to boost exports. The result, Professor Morici argues, is a greater shift of manufacturing jobs out of the United States and into China. And because US factories use much less energy than those in China, this affects demand for oil.

"Every time a job leaves Indiana for Shanghai, oil consumption goes up," Morici says.

Moreover, in his view, China's resulting trade surplus has enabled the country to afford the artificially low fuel prices it sets for consumers – prices that China adjusted upward last week.

Still, it's hard to gauge how much oil demand has been affected by China's currency-managing methods. "Given the rapid economic growth rate, ... I would argue that demand from China would still be relatively robust" regardless of the exchange-rate policies, says Paul Ting, who runs an energy consultancy in Short Hills, N.J.

A financial effect: Low interest rates or rising inflation can cause investors to flee a currency. Those same rates can help drive up commodity prices and cause investors to buy oil contracts as a "hedge" against feared inflation.

One symbol of the problem: Investors holding US dollars now face negative real returns – interest rates below inflation.

The Federal Reserve has reduced short-term US interest rates to counter the threat of recession, but now is walking a fine line as markets increasingly are also worried about inflation.

"The more that people doubt the Federal Reserve's willingness to reverse this policy course they've chosen, the higher oil prices rise," says Tim Duy, an economist at the University of Oregon in Eugene.

In ordinary times, the Fed would focus on helping the economy out of its slump. This month, Fed Chairman Ben Bernanke said the Fed is now also "attentive" to downward pressure on the dollar.

Economists say that much of the global inflation pressure comes from emerging nations. They have kept money supply relatively loose, partly because their dollar-pegged exchange rates effectively link their monetary policy to that of the Fed.

Managed currency rates and fuel-price controls have put particular pressure on oil prices, Merrill Lynch analysts argue in a recent report. "As neither [emerging market] exchange rates nor domestic commodity prices could adjust through market mechanisms, world commodity price ... had to trend sharply higher in an effort to slow down demand," they write.

So it may be a range of exchange rates, not just the dollar, that's affecting oil prices.

How could the dollar be strengthened?

It might happen naturally, if markets decide that the greenback has dropped below its fair value.

Or sometimes, the world’s big governments can use words and currency trades in a concerted way to to affect the dollar.

Another way – controversial given the weakness of the US economy – might be for the Fed to raise short-term interest rates, which would give investors a better return on dollars.