The Dollar Will Decide Oil’s Next Move

Regular readers will know that I believe that one of the most important fundamental influences on the price of oil is the relative strength or weakness of the U.S. Dollar. Obviously according to economics 101 supply and demand ultimately set the price of any commodity, but when, as is the case with oil, that commodity is priced in dollars in a global market the intrinsic value of the dollar is just as important.

Normally the dollar index, which gives the average value of the dollar against a basket of other currencies, moves fairly slowly so judging the impact on oil prices is about predicting long term trends. Sometimes, though, things change quite fast and even short term predictions for oil are dependent on the fate of the dollar. That seems to be the case right now, so traders should be watching the dollar's movement closely.

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Figure 1: Dollar Index 1 Year Chart

In case you have not been following it the dollar index has, like most things, been on the move since the U.S. elections. As the so called "Trump Bump" pushed American assets higher, so the dollar also gained ground. That is normal in times of optimism about U.S. growth, but because of the cause, as well as mounting evidence that OPEC's restrictions on output were actually taking place, oil followed suit, which is not typical. WTI jumped from around $45 at the beginning of November to above $55 at the end of the year.

That is, according to the theory mentioned above, not a sustainable thing, and the evidence for that is in what has happened since the end of last year. The dollar has retraced, losing most of November's gains, but WTI has essentially remained at the same levels, stuck mainly in a roughly defined $52-55 range, and bringing us back into balance.

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One might expect oil to continue to push higher as the dollar retraced, but the fact that that has not happened hints at an underlying weakness in oil, a weakness explained by two things. Firstly, as I pointed out here recently, speculative long positions in WTI futures are at an all time high, which elevates oil's downside price risk and limits the upside. If everybody is already long, there aren't many buyers left, and any potential move down will be exaggerated by those longs bailing out. In addition it is becoming increasingly clear that U.S. producers are stepping up production to at least partially offset the OPEC cuts.

What we have then is a situation where technical and fundamental supply and demand factors are essentially in balance. Growth expectations and OPEC indicate strength, while a rising U.S. rig count and inventories and market positioning suggest weakness. Inevitably at some point we will break out of the range that results from those conflicting signals, and the dollar's next move is the most likely indicator of whether that will be an upward breakout or a downward breakdown.

There are obviously three potential things that can happen to the dollar from here; it can a) go up, b) go down or c) stay in the range and move sideways. The normal inverse relationship between the dollar and oil suggest that if a) happens oil will push below $52, and in the case of b) will jump above $55. I would argue though that, given oil's lack of reaction as the dollar retraced 5% or so in January, scenario c) would also mean a drop in oil prices. If we assume that each is equally likely that means that there is more likelihood of oil breaking down than breaking out to the topside. That is why I am currently short oil by being long the leveraged inverse ETF SCO.

As logical as that position is, though, its success is dependent on the dollar's next move, so I will be watching the index closely in the coming days, and anybody who follows or trade oil should do the same.