The U.S. Dollar Exchange Rate and the Demand for Oil.

• Author: Schryder, Selien De

1. INTRODUCTION

   There is a growing consensus that global crude oil price fluctuations are mainly driven by changes in the demand for oil. Hamilton (2009), for instance, argues that strong growth in world income was the primary cause of the oil price surge in 2007-08, whereas the subsequent dramatic collapse of oil prices was the result of the global economic downturn in the aftermath of the financial crisis. Furthermore, Peersman (2005), Kilian (2009), Peersman and Van Robays (2009), Lombardi and Van Robays (2011) and Kilian and Murphy (2012) disentangle different sources of oil price shocks within a structural vector autoregressive (SVAR) model, and find a dominant role for shocks at the demand side of the global crude oil market. In order to better understand oil market fluctuations, a more detailed analysis of the drivers of oil demand is thus desirable.

   In this paper, we examine the role of the U.S. dollar exchange rate for oil consumption. The U.S. dollar exchange rate has so far been ignored as an independent driver of oil demand in the empirical literature on global oil market dynamics. This is surprising since global oil prices are predominantly expressed in U.S. dollars. According to the local oil price channel, a shift in the dollar exchange rate should then affect the demand for crude oil in countries that do not use the U.S. dollar for local transactions (Austvik 1987). For instance, when the U.S. dollar exchange rate depreciates, oil becomes less expensive in local currency for consumers in non-U.S. dollar regions, boosting their demand for oil. The rise in oil demand for countries that do not use the dollar for local transactions should in turn influence global oil production and oil prices expressed in U.S. dollar. This line of reasoning was raised in the work of Brown and Philips (1984) and Huntington (1986), and is supported by the data shown in Figure 1. The panels in the figure show the evolution of the real effective U.S. dollar exchange rate, as well as the deviation of oil consumption from its trend, for a set of countries (and country aggregates) that are examined in this paper. As can be seen in the figure, an appreciation (depreciation) of the dollar exchange rate is often accompanied by a decline (rise) in oil consumption relative to its trend evolution, indicating a fall (rise) in oil demand. Shifts in the U.S. dollar exchange rate could thus be important for global oil market dynamics.

   A similar argument holds for several studies that exclusively focus on the analysis of the determinants of oil demand. In particular, Gately and Huntington (2002), Cooper (2003), Dargay,

   Gately and Huntington (2007), Narayan and Smyth (2007) and Dargay and Gately (2010) amongst others estimate oil demand functions for multiple countries. These studies consider oil demand as a positive function of income per capita and a negative function of its own price. For the latter, they typically use global crude oil prices expressed in U.S. dollars due to the lack of sufficient and/or reliable data on local oil prices. The influence of shifts in the U.S. dollar exchange rate on oil demand is hence not taken into account. Some studies (e.g. Griffin and Schulman 2005; Dargay et al. 2007; Dargay and Gately 2010; Fawcett and Price 2012) do use local oil/gasoline prices in the estimations, but do not distinguish between local oil price movements caused by global oil price shifts and movements caused by changes in the value of the U.S. dollar. (1) There is, however, no a priori reason to assume that the pass-through and influence of both sources of oil price shifts on oil demand is the same.

   We formally investigate the effects of shifts in the U.S. dollar exchange rate on oil demand in non-U.S. dollar regions, by estimating the determinants of oil consumption per capita for a panel of 65 oil-importing countries over the sample period 1971-2008. A panel data approach is commonly used in the literature on oil (energy) demand, as it allows to exploit both the cross section and the time dimension of the data. We conduct panel estimations for respectively a sample of 23 OECD countries, 42 non-OECD countries and all 65 oil-importing countries. Besides real GDP per capita, we include global real crude oil prices expressed in U.S. dollar, as well as the real U.S. dollar exchange rate in the estimations. An explicit analysis of the role of the U.S. dollar as a possible driver of oil consumption is a first contribution of the paper. (2)

   A second contribution of the paper is methodological. In particular, most existing panel data studies on oil demand do not fully take into account the specific salient features of macro panel data sets such as heterogeneity of the coefficients, unit root behavior and cross-country dependence, even though the neglect of these matters can result in misleading estimation outcomes. We apply recent advances in panel estimation techniques that are capable to handle these econometric issues. Specifically, we (i) take into account the long-run relationship between the variables by estimating a panel error correction oil demand model, (ii) allow for cross-country heterogeneity of the coefficients which is present in the data, and (iii) consider cross-sectional dependence in the error terms. The application of these econometric advances and the addition of the U.S. dollar exchange rate as a driver of oil consumption turn out to matter for some of the estimated elasticities.

   We find that an appreciation of the U.S. dollar real effective exchange rate leads to a decline in oil consumption in non-U.S. dollar regions. Strikingly, the short-run U.S. dollar exchange rate elasticity of oil demand turns out to be substantially larger than the elasticity of oil demand with respect to fluctuations in the global price of crude oil expressed in U.S. dollar. A more detailed analysis of the pass-through of changes in global crude oil prices and the U.S. dollar exchange rate to oil products end-user prices for a subset of 20 OECD-countries suggests that the difference in the magnitudes of both elasticities is the consequence of a significant larger pass-through of exchange rate fluctuations. A back-of-the-envelope calculation furthermore suggests that shifts in the U.S. dollar exchange rate are an economically important contributor to the volatility of the global price of crude oil expressed in U.S. dollar, due to its influence on oil demand. These findings underline that the U.S. dollar exchange rate should be taken into account in the analysis of global oil market dynamics and sources of oil price fluctuations.

   The remainder of this paper is organized as follows. In the next section, we describe the baseline empirical model for oil demand and discuss some econometric issues. Section 3 discusses the estimation and robustness of the results. The pass-through of changes in global oil prices and the real effective U.S. dollar exchange rate to local end-user oil prices is examined in section 4, while the economic relevance of the U.S. dollar exchange rate for global oil market dynamics is assessed in section 5. Finally, section 6 concludes.

2. EMPIRICAL OIL DEMAND MODEL

   In this section, we describe the benchmark oil demand model that will be used in the estimations. Our sample contains 65 oil-importing countries that do not have the U.S. dollar as their local currency and covers the period 1971-2008. (3) Details of the data and a list of the countries can be found in Appendix A. Consider the following general oil demand specification for country i at time t:

   [dem.sub.it] =f([gdp.sub.it],[oilp.sub.t],[rer.sub.t],[trend.sub.t],[c.sub.i]) (1)

   where [dem.sub.it] is total oil consumption per capita, [gdp.sub.it] real income per capita, [oilp.sub.t] the world real U.S. dollar crude oil price and [rer.sub.t] the real effective U.S. dollar exchange rate, [trend.sub.t] a linear time trend and [c.sub.i] a country-specific constant. All variables are converted to natural logarithms, such that the model is of the constant elasticity form. The data are at annual frequency.

   The existing empirical literature typically considers oil consumption, or energy consumption more generally, as a positive function of real income and a negative function of its own price (e.g., Dahl and Sterner 1991; Dahl 1993; Espey 1998; Gately and Huntington 2002; Cooper 2003; Griffin and Schulman 2005; Hughes, Knittel and Sperling 2008; Lee and Lee 2010; Dargay and Gately 2010). In line with these studies, we include country-specific real GDP per capita in the general oil demand specification. Real GDP is assumed to represent the energy-using capital stock, such as buildings, equipment and vehicles (Dargay and Gately 2010).

   As a measure for the own price of oil demand, most studies use the global price of crude oil expressed in U.S. dollar (supra, page 91). However, as we have explained in the introduction, the price that consumers face in countries that do not use the U.S. dollar as a currency for local transactions, is the price of oil determined in dollars multiplied by the country's exchange rate against the U.S. dollar, i.e. the number of units of national currency needed to buy one U.S. dollar (Austvik 1987). Some studies use local oil/gasoline prices in the estimations (supra, page 93), but this does not allow to distinguish between local oil-price shifts caused by changes in the global price of crude oil, or changes in the U.S. dollar exchange rate, which is the central research question in this paper. Moreover, the lack of availability of country-specific end-user prices would constrain the sample considerably. (4) Accordingly, we include the global real crude oil price expressed in U.S. dollar, as well as the real U.S. dollar effective exchange rate as two separate variables in our empirical oil demand model.

   We use the U.S. dollar real effective exchange rate rather than real bilateral exchange rates in the benchmark estimations for...