Sebastian Culpan-Scott (i7957811)

The relationship between the Crude Oil price and the Trade weighted US Dollar Index
Sebastian Culpan-Scott (i7957811) i7957811@bournemouth.ac.uk Economics (BA) Hons Abstract Previous studies have established an inverse relationship between the crude oil price and the trade weighted US dollar index, this paper continues with the investigation of the association between these two variables. This paper uses the daily closing values of crude oil and the US dollar index from 31st December 2008 to 31st December 2012, using regression and time series analysis a clear inverse relationship has been identified between the two variables. The inverse relationship identified in this paper matches the results of previous academic papers (Novotn 2012, Chandrasekhar & Ghosh 2008 & Obadi 2012) and therefore it is possible to conclude that there is a negative correlation between the price of crude oil and the US dollar index. Keywords: Crude Oil, US Dollar, Regression, Time series analysis Introduction The relationship between crude oil and the US dollar has captured the attention of economists for a number of years, with numerous studies being conducted to investigate the connection between them. As commodity prices are mostly denominated in US dollars it naturally leads to a question regarding the relationship between commodity prices and the dollar exchange rate.( Novotn 2012) As crude oil is quoted in US dollars it has led many to believe that there is a clear inverse association between the two variables because a weakening of the dollar against the currencies of countries with floating exchange rates means that the oil price in local currency becomes lower. ( Novotn 2012) Therefore a weakened dollar means that crude oil can become relatively cheaper for other countries and this can result in an increase in the demand for crude oil, which can then lead to the price of crude oil being increased. Chandrasekhar & Ghosh (2008) have also suggest that significant increases in crude oil prices actually signals a depreciation of the dollar, rather than any increase in the price of crude oil. A study produced by Obadi, S.M. (2012) has also gone on to state that the relationship between the two variables has impacts on the international trade of other economies due to effects that oil has on other commodity prices. Descriptive statistics In order to analysis the relationship between Crude Oil and the US dollar index I have collected data of the daily closing values of each variable from December 31st 2008 December 31st 2012 and these data sets can be seen in figure 1. Previous studies (Novotn, F.2012 & Obadi, S.M.2012) investigating this relationship have concluded that there is an inverse relationship between the Crude Oil price and the US Dollar index.

Sebastian Culpan-Scott (i7957811) From looking at the data sets in figure 1, it is difficult to notice an inverse relationship between the two variables due to the fact the price of crude oil fluctuates throughout, where as the US dollar index seems to follow a pretty consistent pattern. In order to establish the relationship between these two variables, a Pearson or Spearmans correlation can be used. Figure 1: Daily Crude Oil ($ per barrel) closing price & Daily US Dollar Index closing rate from Dec 31 2008 Dec 31 2012
140 120 100 80 60 40 20 0 1 30 59 88 117 146 175 204 233 262 291 320 349 378 407 436 465 494 523 552 581 610 639 668 697 726 755 784 813 842 871 900 929 958 987 Crude Oil ($ per barrel) Sources: EIA. (2013), Federal Reserve Bank of St. Louis. (2013) Trade weighted US Dollar Index

In order to use a Pearson correlation, I must first use a Shapiro-Wilks test to check if the data meets the criteria required for a Pearsons correlation to be run.

Table 1: Shapiro-Wilk Testing of Normality

Tests of Normality Kolmogorov-Smirnov Statistic Crude Oil ($ per barrel) Trade weighted US Dollar Index a. Lilliefors Significance Correction .062 .089 df 1005 1005
a

Shapiro-Wilk Statistic .952 .941 df 1005 1005 Sig. .000 .000

Sig. .000 .000

From looking at the results displayed in table 1, it is clear that the Pearsons condition of normality has been violated as the significance of the Shapiro-Wilks shown in table 1 is 0.000 and for the data to meet the condition the significance must be at least 0.05 or greater. As this assumption of normality has been breached I must reject the null hypothesis of normality and accept the alternative hypothesis.

Sebastian Culpan-Scott (i7957811) As the assumption of normality has been violated, I am no longer able to use Pearsons correlation to analyse the relationship between Crude oil and US dollar and must therefore use a Spearmans correlation to distinguish the association between these two variables.

Table 2: Spearmans rank order correlation

Correlations Crude Oil ($ per barrel) Correlation Coefficient Crude Oil ($ per barrel) Spearman's rho Correlation Coefficient Trade weighted US Dollar Index Sig. (2-tailed) N **. Correlation is significant at the 0.01 level (2-tailed). -.824 Sig. (2-tailed) N 1.000 . 1009
**

Trade weighted US Dollar Index -.824

**

.000 1005 1.000 . 1005

.000 1005

The correlation coefficient produced in table 2 is -0.824, which indicates that there is a strong negative correlation between the price of crude oil and the US dollar index. The P-value (sig.2-tailed) of the correlation coefficient which is also produced in the table shows that , as p-value is statistically different from zero it means that we must reject the null hypothesis and accept the alternative hypothesis for the correlation. Regression The scatter plot displayed in figure 2 shows the relationship between the crude oil price and the US dollar index. A clear inverse relationship can be noticed when looking at the scatter plot as the plots are decreasing from left to right. The inverse relationship that has been identified in figure 2 coincides with the findings in the academic papers of Novotn (2012) & Obadi (2012) and the results produced by the Spearmans correlation (table 2). Figure 2: Crude Oil and US Dollar Index Scatter plot

Sebastian Culpan-Scott (i7957811) In order to display the strength of the negative relationship shown in figure 2, I have added a line of best fit which can be seen in figure 3. The scatter plot in figure 3 shows the strength of the negative relationship and corresponds with the -0.824 correlation coefficient produced in the Spearmans correlation table (table 2). Figure 3: Crude Oil and US Dollar Index Scatter plot with Line of best fit

The results created in table 3 show the multiple correlation coefficient (R) and the percentage of variance (R2) in crude oil. The correlation coefficient (R) in table 3 is 0.875 which indicates a strong association between dependent and independent variable, in this instance it means that any shift in the US dollar index can consequentially lead to a change in the price of crude oil, these results can be linked with the finds of Chandrasekhar & Ghosh (2008). The percentage of variance (R2) in crude oil on this occasion is 0.765, the R2 results in table 3 mirror the results produced for the adjusted R2 this signals that there is very little positive bias in the R2 value. Using the adjusted R2 displayed in table, it is possible to conclude that the 76.5% of the variability in the crude oil price can be explained by the US dollar index value. Table 3: Model summary
Model Summary Model R R Square Adjusted R Square 1 .875
a b

Std. Error of the Estimate

Durbin-Watson

.765

.765

7.88976

.065

a. Predictors: (Constant), Trade weighted US Dollar Index b. Dependent Variable: Crude Oil ($ per barrel)

Sebastian Culpan-Scott (i7957811)

The Durbin-Watson produced in table 3 is 0.065, this result indicates that there is a strong positive autocorrelation between these two variables. This positive autocorrelation could be down to the fact that stock prices tend not to change too radically from one day to another and therefore the prices from one day to the next could potentially be highly correlated.(Investopedia 2013) This statement can be directly linked with the data used for this paper as the data sets used involve the daily closing prices of crude oil and the daily closing value of US dollar index. However, as the results produced in table 3 indicate that there is strong autocorrelation, the null hypothesis can be rejected. A histogram can be used to show the distribution of the residuals and the histogram displayed in figure 4 shows that the residuals for crude oil appear to have a normal distribution. In order for the conditions of a normal distribution to be met, the mean and the standard deviation have to be as close to 0 and 1 respectively, these requirements have been met and can be seen in figure 4. Figure 4: Crude Oil ($ per barrel) Histogram with line of normality

To confirm that the residuals shown in figure 4 have a normal distribution, a normal P-P plot can be used to check the distribution of the residuals. In order to verify that the distribution of the residuals is normal, the residual values should run precisely along the diagonal line. However, when the P-P plot is created using actual data the residuals do not always perfectly align along the line, this can be clearly seen in figure 5 where the residuals run closely and not spot on to the diagonal line. As the residuals run closely to the diagonal line it is possible to conclude that the distribution is normal and therefore coincides with the normal distribution shown in the histogram displayed in figure 4.

Sebastian Culpan-Scott (i7957811)

Figure 5: Crude Oil Normal P-P Plot of Regression Standardized Residual

In order for the data to meet the conditions required for a regression model to work I must analysis the residual scatter plot shown in figure 6. The assumption requires the variance for the dependent variable to be constant throughout, this assumption is known as homoscedasticity.(Dougherty 2007) Figure 6 shows that the condition of homoscedasticity has been met, as the line of best fit illustrates that the residuals have the same dispersion throughout. Figure 6: Regression Standardized Residual scatter plot

Sebastian Culpan-Scott (i7957811) The F-test shown in the ANOVA table below can be used to determine which model is best suited for evaluating the variables. In this instance the model can be considered to be statically significant at F(1,1003) = 3260.812, where the significance level is produced in the table is 0.000. Due to being statistically significant from zero, I must reject the null hypothesis and accept the alternative one. (Dougherty 2007)

Table 4: ANOVA table

ANOVA Model Regression 1 Residual Total Sum of Squares 202979.902 62435.010 265414.912 df 1 1003 1004
a

Mean Square 202979.902 62.248

F 3260.812

Sig. .000
b

a. Dependent Variable: Crude Oil ($ per barrel) b. Predictors: (Constant), Trade weighted US Dollar Index

By applying the results displayed in the coefficients table to a linear regression model ( = ) I will be able to predict the Crude Oil price given the parameters and the US dollar index value. (Dougherty 2007)

Table 5: Coefficients
Coefficients Model Unstandardized Coefficients B Std. Error
a

Standardized Coefficients Beta

Sig.

95.0% Confidence Interval for B Lower Bound Upper Bound

(Constant) 1 Trade weighted US Dollar Index

437.375 -3.509

6.219 .061 -.875

70.326 -57.104

.000 .000

425.171 -3.630

449.579 -3.389

a. Dependent Variable: Crude Oil ($ per barrel)

Once the figures from table 5 have been inserted into the linear regression model, the regression equation for predicting the crude oil price is:

Adding the error term to this regression equation will make it possible to calculate the actual crude oil price. In order to conclude that the regression coefficients produced in table 5 are the best linear estimators (BLUE), I must ensure that the Gauss-Markov conditions have been satisfied. (Dougherty 2007)

Sebastian Culpan-Scott (i7957811) The presence of autocorrelation in the model which has been identified by the Durbin-Watson (table 3) means that one of the Gauss-Markov conditions has been violated, this condition violation does not make it possible to conclude that the regression coefficients are the best linear unbiased estimator (Blue). Time series plot The Durbin-Watson results displayed in table 3 have indicated that there is a strong autocorrelation between the two variables being investigated. Using time series analysis, I will examine the association between the variables further and find additional evidence to back the findings produced by the Spearmans rank order correlation. Time series is A sequence of numerical data points in successive order, usually occurring in uniform intervals. (Investopedia 2013) Figure 7: Crude oil ($ per barrel) and Crude oil 30 day moving average between Dec 31 2008 Dec 31 2012
120 100 80 60 40 20 0 1 29 57 85 113 141 169 197 225 253 281 309 337 365 393 421 449 477 505 533 561 589 617 645 673 701 729 757 785 813 841 869 897 925 953 981 1009 Crude Oil ($ per barrel) Source: EIA. (2013) Crude Oil 30 day moving average

From looking at figure 7, it is clear that the crude oil price has a positive upwards sloping trend over this time period with slight fluctuations throughout. It could also be argued that there is a cyclical pattern present in figure 7 as there are slight fluctuations throughout, however no to the severity of a business cycle.

Sebastian Culpan-Scott (i7957811) Figure 8: Trade weighted US Dollar Index and US Dollar Index 30 day moving average between Dec 31 2008 Dec 31 2012
140 120 100 80 60 40 20 0 1 29 57 85 113 141 169 197 225 253 281 309 337 365 393 421 449 477 505 533 561 589 617 645 673 701 729 757 785 813 841 869 897 925 953 981 1009 Trade weighted US Dollar Index Source: Federal Reserve Bank of St. Louis. (2013) US Dollar Index 30 day moving average

Figure 8 displays the trade weighted US dollar index and the 30 day moving average between the 31st December 2008 31st December 2012. There is a negative down sloping trend in this time series, with minimal evidence of any cyclical or seasonal trends throughout this time period. Having established the trends of each variable it is possible to conclude that there is an inverse relationship between the price of crude oil and the US dollar index, because over this time period there is an evident positive trend in the price of crude oil and there is an obvious negative trend in the US dollar index. These findings coincide with the results produced in the spearmans correlation table (table 2) and link in with the distribution of the scatter plot displayed in figure 2. Concluding remarks Having examined the relationship between the crude oil price and the weighted US dollar index, a inverse association has been established between the two variables. To discover the relationship between the variables, the Spearmans rank order correlation produced a negative correlation of 0.824 (table 2) and the scatter plot (figure 2) revealed a clear downward sloping negative relationship. To back up the results produced, a time series analysis was used, with crude oil (figure 7) displaying a positive trend and the weighted US dollar index displaying a negative trend. As the findings of this paper coincide with the results produced in previous academic studies it is possible to conclude that there is a clear inverse relationship between the crude oil price and the weighted dollar index, with the adjusted R2 (table 3) indicating that 76.5% of the variability in the crude oil price can be explained by the US dollar index value. However, as one of the Gauss-Markov assumptions being violated due to the presence of autocorrelation, the ordinary least squares (OLS) regression can not be considered to be the best linear unbiased estimator (BLUE).

Sebastian Culpan-Scott (i7957811) References Chandrasekhar,C.P & Ghosh, J. (2008). Oil Prices and the US Dollar. Available: www.networkideas.org/news/mar2008/oil_prices.pdf. Last accessed 19th April 2013. Dougherty, C (2007). Introduction to Econometrics. 3rd ed. Oxford: Oxford University Press. pp1-336. EIA. (2013). Petroleum & Other Liquids. Available: http://www.eia.gov/dnav/pet/pet_pri_spt_s1_w.htm. Last accessed 12th April 2013. Federal Reserve Bank of St. Louis. (2013). Trade Weighted U.S. Dollar Index: Broad (DTWEXB). Available: http://research.stlouisfed.org/fred2/series/DTWEXB/downloaddata. Last accessed 12th April 2013. Investopedia . (2013). Durbin Watson Statistic. Available: http://www.investopedia.com/terms/d/durbin-watson-statistic.asp. Last accessed 18th April 2013. Investopedia . (2013). Time Series. Available: http://www.investopedia.com/terms/t/timeseries.asp. Last accessed 21st April 2013. Novotn, F. (2012). The Link Between the Brent Crude Oil Price and the US Dollar Exchange Rate. Prague Economic Paper. 2 (2), pp220-232. Obadi, S.M. (2012). To what Extent Do Oil Prices Depend on the Value of US Dollar: Theoretical Investigation and Empirical Evidence. Crude Oil Exploration in the World. 1 (1), pp181-202
The Economist. (2008). Oil and the dollar . Available: http://www.economist.com/blogs/freeexchange/2008/06/oil_and_the_dollar. Last accessed 16th April 2013. Williams, N & Lewis, B. (2011). How logical is the link between oil and the dollar?. Available: http://in.reuters.com/article/2011/07/19/idINIndia-58328120110719. Last accessed 16th April 2013.