The sharp, greater-than-20% drop in crude oil prices from its highs in June reflects dramatic changes in the marginal supply of oil, shifting expectations for demand and, critically, a change in the outlook for monetary policy. The resulting stronger dollar is weakening its equivalent measure in the price of oil. As my colleague Russ Koesterich points out in a recent post, this trend has produced some unexpected winners.  Today, I’m going to go a step further to explore why oil prices have declined and what this means for the economy.

 The Reasons Behind the Decline

The drop in crude oil prices can be attributed to three simple reasons— demand, supply and the dollar. On the demand side, a downgrade in the IMF’s global growth forecast for 2015 in early October coincided with continued eurozone weakness, punctuated by very weak German manufacturing data for August and an un-anchoring of long-term inflation expectations. Furthermore, the latest economic data from Japan showed an economy struggling to cope with the consumption tax implemented in April, with a large drop in GDP and consumer spending. And over the summer, China oil consumption disappointed, even above that expected along with its declining growth.

On the supply side, the long-run U.S. shale oil renaissance has helped propel U.S. crude oil production from a low of about 5 million barrels per day in the mid-2000s to a 30-year high of about 8.7 million barrels per day. This structural trend intersected a series of positive supply developments over the last three months, including airstrikes against ISIS, the re-opening of Libyan ports, the fading of risks surrounding Russian oil supply and increasing Iranian shipments. Finally, Saudi Arabia signaled that it would no longer act as the marginal producer of oil, and instead committed to maintaining market share.

Another important relationship is that with the dollar. Commodities such as oil are dollar denominated and oil can be viewed as another store of value, much like gold or FX. As the dollar strengthens, the value of oil relative to the dollar falls. The correlation between changes in the U.S. dollar and oil prices has been quite strong historically (see chart below), and indeed, the fall in crude oil prices has coincided with the strength of the dollar, strength that reflects stronger relative U.S. economic performance.

US Dollar vs. Brent Crude Oil Prices

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