How European Socialists Tripped Up the Oil Market

There are a good number of investors who went into 2014 thinking that having long-term exposure to oil prices was a good idea.

I’m one of those people.

In recent years, the price of WTI oil had traded in a pretty stable band from $80-110, and had really spent most of the time in an even narrower band between $90-105. Oil producers, investors, lenders to the energy sector, OPEC nations and everyone involved were able to enjoy this stability.

Those were the good old days.

In 2015 volatility is back, and it is back with a vengeance.

It isn’t like most of us forgot that the oil business is a cyclical and volatile one. We only have to think back six years to 2008, when the price of WTI crude ranged from a high of $150 all the way down to a low $33.87.

I think a lot of us with investments exposed to oil didn’t forget that busts like this can happen… I think we just forgot how bad a big drop in oil prices (and owning investments that are linked to the price of oil) feels while actually experiencing it.

Despite the recent pain, which I think could continue for a few more months, having long-term exposure to oil is a must. The long-term fundamentals of the business have not changed. All of the new sources of oil that we are tapping into (shale, offshore, oil sands) require high oil prices. Without high prices, we simply won’t have sufficient daily oil production.

In the long term, a drop in oil prices like this is just a blip on a graph. Again, think back to 2008/2009, when the low points for oil really only lasted a few months.

Crude Oil Spot Price – Past 10 Years

The difficult part is that in the short term, it is nerve-racking to live through the bust, because it is very hard to convince yourself that the drop is only temporary.

I’ve been studying up on this oil drop virtually every day since it became apparent that this was more than a little bump in the road. My desire has been to know what caused this kind of a severe fall. Back in 2008, it didn’t take a rocket scientist to figure out what was going on. At that time, the world had basically fallen apart and oil demand had been crushed.

This time around, it isn’t quite so simple.

The most talked about reasons for the oil price decline are surging U.S. shale production, Saudi Arabia abdicating its role as swing producer and a slowdown in oil demand from China, Europe and Japan.

All of those factors have had an impact in my opinion.

But there is something else at play here, and my colleague Matt Insley was onto it back at the start of September when he wrote this article and gave us this prescient warning:

“For oil prices, as with any commodity downturn, we may be surprised on the downside, too.”

Kudos to Matt for making this prediction… although, I know he too is floored by how low oil has subsequently gone.

In his article, Matt discussed the link between a strengthening U.S. dollar and the price of oil. As you can see by the stunning chart below, when Matt wrote this back in September, it really was just the tip of the iceberg for both oil and the dollar index.

U.S. Dollar Index vs. Crude Oil Sport Price

Isn’t that correlation incredible? The drop in oil and the strengthening of the U.S. dollar started at exactly the same time, and the rate of the moves has accelerated and slowed at exactly the same time.

I have wondered more than a few times how a 2% oversupply of oil (the current situation) could be enough to create more than a 50% drop in prices? When I look at this chart, it is impossible not to think that there is more than supply-and-demand fundamentals of the oil market at work here.

There is, of course, a fundamental impact on demand because of the strengthening dollar. Since oil is priced in U.S. dollars, as the dollar rises, barrels of oil become more expensive to consumers of oil in countries where currencies have weakened against the greenback.

But while the U.S. dollar index has risen by a little more than 10% since July (a huge move in the currency market), the price of oil has dropped 50%. That means that for buyers of oil in any country, including those that have had their currency weaken against the dollar, the price of oil has dropped significantly in recent months.

Noting the dollar/oil correlation shown in the chart above, for those of us dearly looking for a rebound in oil prices, it seems that a weakening or at least levelling off of the U.S. dollar would be very much welcome.

What then might stop this rise in the U.S. dollar?

I mean, we are, after all, talking about the currency of the most heavily indebted country in the world. A country that has over the past five years partaken in an easy money policy of unprecedented proportions.

Put bluntly, less than a decade ago, the U.S. dollar was kryptonite — suffering from decades of decline. But today, the tides have turned for the buck.

So what gives?

To understand what might stop this rise in the U.S. dollar index, we need to understand the components of the index.

Weights of ICE Futures U.S. Dollar Index (USDX)

Yep, that is it. The entire index is made up of six currencies total. Ninety percent of the index is made up of only four countries. More than 70% of the index is the euro and yen, and more than half the index is the euro alone.

Remember how I was wondering how the U.S. dollar index could be strong? It isn’t hard to figure it out when you see what the index is made up of. The euro and yen are really the dynamic duo of currency disasters.

The strength in the U.S. dollar is truly a case of being by far the cleanest dirty shirt in a very dirty laundry basket.

While the U.S. is the most indebted nation in the world, both Europe and Japan have higher debt-to-GDP ratios. According to Lacy Hunt of Hoisington Investment Management, based on the most recent available data, debt in the U.S. sits at 334% of GDP, while the eurozone is at 460% and Japan is 655%.

Further strengthening the U.S. situation is that the American economy is growing at a decent clip, while the eurozone and Japan aren’t.

So not only does the current picture look brighter for the U.S. dollar, so does the near future.

In the United States, the Fed has ended its quantitative easing tactics, which is good for the dollar, and is starting to get closer to actually raising rates. Rising rates are going to encourage investors wanting yield to demand U.S. dollars and will also cause investors who have borrowed U.S. dollars to invest elsewhere to reverse that carry trade in order to avoid paying the higher interest cost.

Meanwhile, the eurozone is on the verge of commencing significant easing measures to try to jump-start their collective economies, and Japan is in the midst of a mind-boggling quantitative easing experiment designed to shake off a multidecade funk.

Looking ahead, nothing on the horizon would suggest the dollar is going to do anything but strengthen.

But it’s always darkest before the dawn. And the U.S. Federal Reserve is already showing signs that it is concerned about the rising dollar and is dropping hints that might slow its roll.

Last week, Federal Reserve Bank of Atlanta President Dennis Lockhart noted that he thinks the Fed would be well served to take a very cautious approach to raising rates. The Fed knows that a dollar that continues surging would inflict huge damage on economies across the globe, which would then directly impact the U.S. as well.

It’s going to take some time for this dollar drama to play out. And in the meantime we’ll likely have to stomach some market volatility in the hopes of finding long-term opportunities.

The last time we saw a strong dollar and a huge pullback in oil prices (2008/2009), it marked one of the best buying opportunities we’ve seen in decades.

Plan on hearing more from me as this story unravels. Stay tuned.

Jody Chudley
for The Daily Reckoning

[Ed. Note: Our newest contributor, Jody Chudley is an old hand in the oil market. He’s also got a great pulse on the global resource space. More recently, in the past five years or so, he’s covered the nuts and bolts of North America’s shale scene. Keep up to date with Jody’s commentary with a free subscription to Daily Resource Hunter. Click here now.]

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