Even though the lack of meaningful US economic data has kept the US dollar in flux, there is one commodity that is continuing to grind lower. Oil prices fell to the lowest level in 20 months as exporters wake up to reality that crude prices may stay at current levels for some time.

For the currency market, the decline in oil prices is bullish for the US dollar, and Japanese yen but bearish for the euro and Canadian dollar. The weakness of US stocks will also add pressure on high yielding currencies Since the beginning of the year, there has been a 70 percent positive correlation between the EUR/USD and the price of oil.

With the fear of weakening global demand keeping oil prices under pressure, OPEC nations are starting to realize that production cuts may not be the answer. The strong rise in commodity prices that we have seen throughout 2006 and into the summer of 2008 was driven by the frothy expectations that the global economy will continue to expand at a healthy pace. That of course has been proved to be false.

Now that oil prices have dropped more than 50% since the summer and have refused to recover, oil exporters have resorted to hedging their oil exports at sub-$100 levels. The front page story in the Financial Times today talks about how Mexico, the world’s sixth largest oil producer is hedging nearly all of next year’s oil exports. This is a clear sign that they fear oil prices will remain below $70 a barrel in 2009. Even though the report only talks about Mexico, we doubt that they are the only oil producing country to start hedging.

In order to hedge against a drop in oil prices, oil producers need to enter into derivative contracts that basically involve selling oil prices forward.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.