A Significant Fundamental Shift for Oil Amongst All of the Noise

It has been another wild week for those of us that track and trade the oil market. It started with a two day decline of nearly 15 percent and then over the next two days oil futures recovered almost all of that before turning tale again on Thursday afternoon. Given the degree of volatility we have experienced since the start of the year it is tempting to look at this week of just more of the same, but there is a difference. One fundamental thing changed this week that has shifted the long term outlook and it came from outside the oil market.

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The turnaround in the futures and oil's massive, roughly 10 percent spike on Wednesday, even in the face of yet more bad news on the inventory front, came as the result of two factors. The most quoted reason, rumors of some kind of emergency meeting involving OPEC and non-OPEC oil producing countries, was actually the least significant from a long term perspective.

There have been similar rumors several times over the last few months, but so far nothing has come of them. Even if this time is different, though, it is easy to overestimate the importance of such a meeting as neither of the World's two largest oil producers would be a part of it. The biggest, the U.S. doesn't make centralized decisions about oil but rather leaves that to the market and the second biggest, Saudi Arabia clearly indicated their contempt for the idea by immediately cutting prices and increasing production even further on Wednesday. They are more concerned with the geopolitical implications of Iranian oil hitting the market than with price right now and seem determined to make it as difficult as possible for that oil to find a profitable market. Without those two, who produce more than the next five countries combined, the effects of any agreement would be limited.

The other thing that drove prices up on Wednesday, however, could well have a lasting impact on prices. In separate comments, two Federal Reserve officials used language that strongly suggested that the second rate hike that the market was anticipating in March may not come. Interest rates, or the expectations for them are the most fundamental driver of foreign exchange, and the relative strength of the dollar is one of the most fundamental drivers of the price of commodities, including oil.

Oil's ongoing malaise is a function of all three of the major drivers of price. Global production has increased and there are worries about future global economic growth, so both supply and demand are contributing. The one that often gets overlooked, however, is the effect of a strong dollar. Oil is priced in dollars so, by definition, if dollars are generally worth more, oil is worth less. Add to that that dollar strength makes oil relatively more expensive in countries using other currencies which in turn depresses demand, and it is easy to see the importance of forex for oil prices.

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Figure 1: Dollar Index 1 Year Chart

The dollar index, a broad representation of the dollar's value against a basket of currencies had, since the beginning of December, been in a clearly defined rising channel pattern. A U.S. rate hike in March, and even subsequent increases, was already priced in at those levels so when that conventional wisdom was challenged on Wednesday the dollar collapsed, taking it out of that channel. We are now at levels not seen since October when, it should be noted, oil was trading at close to $50.

Now, I am not suggesting that we are going roaring back up there immediately. I am not even suggesting that we are going immediately higher from here. The supply and demand factors will still weigh on the commodity, but if we do track back below $30 over the next couple of days I will view it as a major buying opportunity.

So, as another week marked by massive volatility in the oil markets draws to a close there is at least some relief on the horizon. Assuming that the dollar remains at these lower levels support for oil at or just below the $30 level looks inevitable and the longer it stays that way the more likely it is that we have finally found a bottom.