The relationship between oil price and FX rates
As commodities go, oil is the lifeblood of the global economy. Fluctuations in value affect every currency in several ways, including inflation, changes to interest rates and economic growth. More audacious traders use this knowledge by factoring oil trade data into their trading strategies. But why are oil prices and foreign exchange rates so closely aligned? Let’s take a look.
Sebastian Steyn ● Feb 25, 2025
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Currencies, economic growth and inflation - where does oil fit in?
Inflation is a major indicator of how oil prices impact forex rates. When oil prices rise, this has a domino effect on goods and services. This causes higher inflation which, in turn, causes banks to raise interest rates. This also impacts investor interest, leading to an appreciation in a domestic currency.
Another aspect worth considering is economic growth. Oil is a critical energy source for everything from transportation and manufacturing to agriculture. Any changes in its price can greatly influence the profitability of these and other industries and, eventually, the economic growth of a country.
Of course, this also means that price increases lead to higher costs for companies which lower profits. In extreme cases, this may result in job losses and reduced consumer spending, meaning a weaker domestic currency.
To get a better understanding, we need to go back to the 1970s when the lines between the oil trade and foreign exchange rates started to merge.
What was the petrodollar system and how did it work?
The petrodollar was introduced in 1974 after two major events shaped that decade. These were the collapse of the Bretton Woods System in 1971, a system created to rebuild economies after World War II, and the 1973 oil crisis when the Organization of Arab Petroleum Exporting Countries placed a total oil embargo on oil against all nations that supported Israel during the Yom Kippur War.
The petrodollar’s creation between the US and Saudi Arabia was a major turning point in global trade since both nations agreed oil prices would be set exclusively in US Dollars to curb any potential risks for exchange rates. It also saw the exchange of support and military equipment from the US in exchange for Saudi oil.
The knock-on effect of the agreement was that countries needed to hold major reserves of US Dollars to conduct oil trade. This strengthened the USD’s value and improved its stability. It also created a consistent global demand for the Dollar.
The petrodollar system had its drawbacks, too. It risked trade imbalances – when a country’s imports or exports are out of balance, leading to either a trade deficit or surplus – and a dependency on oil prices, which affects economic inequality on a global scale.
Why did the petrodollar system end?
What was once the de facto petrocurrency officially expired on 9 June 2024 when Saudi Arabia chose not to renew the 50-year petrodollar agreement. This could be based on the value of many nations’ increasingly stronger ties with China. This eclipsed their relationships with the US and Europe combined. Imports and exports from the Asian giant totalled $87.3 billion in 2021 alone.
Earlier this decade, the US, meanwhile, placed a stronger focus on shale in 2012 which changed the dynamics of the petrodollar twelve years before its end. This shift turned the US from being a net energy importer into becoming an exporter instead, directly affecting the value of the petrodollar itself.
The legacy of the petrodollar
An indirect effect of the petrodollar system was that it acted as a fixed exchange rate for oil-exporting countries. This is known as a currency peg, a government policy that ties a nation’s currency to another or other valuable commodities, like gold or oil.
Ironically, the Dollar’s use as a peg mirrors the gold standard. Part of the Bretton Woods system's demise saw the US stop converting the Dollar to gold at $35 per ounce. This came 38 years after the US Congress enacted a resolution voiding creditors' right to demand payment in gold. In 1971, President Nixon announced that Dollars would no longer be converted to gold at a fixed rate. This was the final step in the country thoroughly abandoning the gold standard.
Countries pricing their oil in Dollars – the world’s primary reserve currency – generates a degree of monetary stability because their value is linked to US currency. As such, when the Dollar appreciates, so does their own. Of course, this also happens in the reverse. The Dollar’s depreciation would impact their own, affecting trade and other economic policies. It should also be noted that fluctuations in the Dollar’s value affect nations with major crude oil reserves (Russia, Canada and Brazil) more than countries that aren’t major oil exporters.
The petrodollar also bolstered the global demand for the Dollar, which lowered interest rates in the US. US borrowers benefitted from access to securing capital at lower interest rates and fuel funding for domestic investments and other kinds of economic growth.
The other and probably the most significant aspect of the petrodollar was that it strengthened the US’s geopolitical sphere of influence, giving it an advantage in moulding international developments, economically and politically. It also helped the country enter other trade agreements.
The new world of petrocurrencies
With the end of the petrodollar, other countries have moved to using their currencies for oil trade instead. Let’s take a look at some examples.
China
China is the second-largest economy in the world, with a GDP of $17.963 trillion. The petroyuan was introduced in 2018 and was meant to compete with the petrodollar as the primary oil-trading currency. A futures market was opened in March 2018 to boost the use of the Yuan as a petrocurrency.
Venezuela
Similar to China, Venezuela launched the petro in February 2018. However, the South American nation launched it as a cryptocurrency instead. Unlike other coins, this one was developed by the government of Venezuela and is backed by the nation’s mineral and oil reserves.
Iran
Iran took a different approach by opening a national exchange where commodities like oil and natural gas are traded. The Iranian Oil Bourse was opened on the free trade zone on Kish Island specifically for the oil trade where other foreign currencies like Euros are used.
Could a new BRICS currency challenge the Dollar?
During a summit in October 2024, BRICS – originally composed of Brazil, Russia, China and South Africa but now includes Egypt, Iran, the United Arab Emirates, Saudi Arabia, and Ethiopia – discussed the possibility of a new reserve currency. This new currency, dubbed the “Unit”, would be backed by a pool of the member countries’ respective currencies.
The Unit would allow these nations to assert economic independence free from the Dollar, which accounts for over 90% of currency trading globally. BRICS’ shift would only build on the Dollar’s loss of momentum in the oil trade over recent years. In 2023, one-fifth of oil trades were reported to have been made in non-Dollar currencies compared to previous years when nearly 100% of oil trading was conducted in USD.