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The price of oil used to be all-important for US dollar prospects. Its importance has declined recently but that may prove temporary, writes Ciaran Kane.

Oil and exchange rates have dominated headlines of late but the two have generally been deemed separate issues. The effects of the ongoing gulf-oil leak has become a huge political issue, with important consequences for equity prices, future oil extraction and even oil demand.

Meanwhile in the world of foreign exchange, the evolution and impact of the euro area's fiscal problems remain the focus. We think that the price of oil remains an important driver of currency rates, the US?dollar (USD) in particular, and that recent issues have masked rather than changed the relationship.

There are three reasons the importance of oil to the EUR/USD may have lessened, which have different implications for the future:

 1) the impact of a change in the oil price on EUR/USD may have fallen;

2) the price of oil may have stopped moving so much;

3) other factors may have become more important and swamped the impact of oil-price changes. We consider each in turn.

We previously argued that the strong negative relationship between the oil price and the USD in 2008 was due to three factors:

• The US is more energy intensive than Europe and therefore suffers a negative

terms-of-trade shock when the price of oil increases. This is a USD-negative if the oil price increase is not due to stronger US demand for oil. In our view, this channel remains in place.

• The Fed and ECB respond differently to oil-price rises. The Fed concentrates on core inflation and places greater weight on employment than the ECB, which leads to US short-term interest rates tending to fall relative to those in Europe in the face of higher oil prices.

However, that may not be the case at present because higher oil prices are likely to be associated with improved global growth prospects and the Fed appears closer to tightening policy than the ECB.

• The countries that benefit most from higher oil prices (notably Opec) tend to import more from the euro area than the US. Demand for euro-area goods and services, therefore, benefits in relative terms when oil prices rise, especially if the rise is due to stronger demand.

This is probably still true but is less important than the other two factors, in our view.

We would therefore expect the oil price and EUR/USD to be positively correlated, but that the strength of the relationship may have declined. Oil-price volatility has also subsided somewhat following the great swings of 2008-2009.

Perhaps more importantly, the price of oil has shown no clear trend over recent months, leading to no persistent effect on EUR/USD.

Finally  euro area-specific issues have clearly become more dominant for FX recently. Investors used to appear interested in all currencies other than the EUR (eg, when discussing EUR/USD, the focus was the US; EUR/GBP, the UK; EUR/SEK, Sweden and so on) - that is certainly no longer true.

All three factors therefore seem to have played a part in the recent decline in importance of oil for EUR/USD. But the lack of clear direction coming from oil's recent lack of importance for EUR/USD is unlikely to persist because there remains good reason to think that the oil price matters for the currency.

So where next for the oil price, and how might it affect EUR/USD?

Prospects for the oil price

Increased risk aversion, uncertainty coming from the euro-area crisis and worries about the durability of Chinese growth have outweighed generally positive macroeconomic and oil fundamental data in the recent past.

However, the focus increasingly seems to be on factors that might moderate growth in specific regions, rather than fears that the entire global economic recovery will be derailed. It will be a rocky road but we expect fundamentals to dominate and oil prices to rise.

US demand data continue to provide evidence of a normalisation of the US oil market and, with the exception of Europe, demand from the OECD economies, in general, has picked up.

In particular, distillate demand has started to show signs of life, with the associated inventory restocking cycle and goods movement providing support. As a result, the oil market is witnessing a synchronised recovery globally.

We expect this trend to continue and underpin price rises in the coming quarters. Benchmark crude levels are already starting to climb back towards $80/bbl, which we view as consistent with the fundamentals. We expect prices to remain above that level for the rest of the year.

In the longer term, non-OECD economies are likely to dominate oil demand growth as the consumption of resources will rise in tandem with increasing wealth. China overtook Japan as the world's second biggest consumer of oil in 2003, and its contribution to demand growth is even more significant.

China has accounted for 40% of the growth in global demand in recent years, more than twice the contribution of the entire OECD. And it is far from alone - demand is growing quickly from other Asian countries such as India and the Middle East.

It seems unlikely that the increase in demand can be met by a similar increase in supply. Existing fields were the easiest to exploit and have entered steep decline. Indeed, the struggle in ramping up new production fast enough is already starting to be reflected in generally disappointing non-Opec supply.

The Macondo spill is likely to create some further significant long-term consequences. Policy on demand-side measures, carbon legislation, supply substitution and energy regulation are all likely to be affected.

But overall, we think that the supply-side consequences are likely more severe than the postponement of Gulf Coast volumes. Oil production will be more politicised, slower onstream, more expensive to produce, and there will be less of it.

It appears to us that the global economic crisis only postponed an oil crunch which otherwise would now be starting to bite. While the recession alleviated tight supply conditions in the short term, it has aggravated them in the medium to long term.

Short of a deep and long-lived demand depression, we think that there is an increasing likelihood of a supply crunch in the coming years.

All those factors mean that we think current oil futures prices are undervalued at current levels of a shade below $100. Thus, the possibility of supply keeping up with demand remains slim. This requires a higher price to clear the market.

Implications for EUR/USD

There are several important takeaways from our views of future oil-price changes.

• The price of oil is likely to be on a secular uptrend in real terms. Even if the US authorities are able to reduce the oil-intensity of the economy, it seems likely that the US will remain significantly more oil-intensive than Europe. This will be a long-term weight on the USD.

• Higher prices are likely to be driven both by non-OECD demand and limited supply.

Because the demand increase is not coming from the US, both developments will be more like a negative supply shock to the US, because it will likely lead to higher prices and weaker output.

• Higher oil prices would be alleviated if global demand gets stuck in a prolonged recession. That would likely be associated with increased nervousness among investors and probably, at least at first, USD strength.

Both the oil price and the USD would therefore be negatively correlated with global demand, which works in the same way as the causal links between them discussed above.

In short, we think that the recent absence of oil as an important driver of EUR/USD is likely to prove temporary, and we expect oil to be an important longer-run weight on the USD.

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