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Why energy traders should fear a rising US dollar

Why energy traders should fear a rising US dollar

As all commodity investors know, commodities cycles are directly correlated to the strength of the US dollar. Since all commodities are denominated in US dollars, commodity prices fall when the US dollar is strong and rise when the US dollar weakens.

US Dollar Index Explained: The strength of the US dollar measured by an index which represents a basket of 6 foreign currencies weighted as follows:
→ 57.6% Euro
→ 13.6% Japanese yen
→ 11.9% Pound sterling
→ 9.1% Canadian dollar
→ 4.2% Swedish krona
→ 3.6% Swiss franc
The index was introduced in 1973; the Euro was added in 1999. The index hit an all-time high of 164.7 in February of 1985 and more recently hit an all-time low of 70.7 in March of 2008.

So how does one gauge the strength of the US dollar? The US Dollar Index was introduced in March 1973 and represents a weighted average of 6 foreign currencies. When the US dollar gains strength, the US Dollar Index goes up as foreign currencies weaken. Conversely, when the US dollar is weak, the index drops as foreign currencies strengthen in comparison.

In the past 50 years, the commodities versus US dollar relationship went something like this:

  • The previous bull market cycle for the commodities occurred in the 1970's when the US dollar was weak.
  • Commodities peaked in 1980 then began a 20 year bear cycle as the US dollar began to strengthen sharply.
  • Commodities bottomed in late 2001 which then began the next commodities bull market as the US dollar weakened.
  • The US dollar hit an all-time low in 2008 just as commodities peaked before the financial market collapse in late 2008. 

So where are we now and how does all this effect the crude oil market? Let's take a look at the more recent relationship between crude oil (more specifically West Texas Intermediate) and the US Dollar Index:

 
usd-index-vs-oil-prices.jpg
 

Crude oil prices are plotted on the top half (in blue) and the US Dollar Index is plotted on the bottom (in grey). Although it's not a perfect correlation, the above chart shows how the two markets trade in opposing directions. But let's dissect the numbers a little further . . . 

 
10yr-USD-WTI-correlation.jpg
 

The past decade went something like this:

  • The US dollar dropped to an all-time low in April 2008. Crude oil peaked at $145/barrel a few months later in July 2008.
  • The financial market collapse began in late 2008 which caused money to flow back into the US dollar. The US dollar hit an interim high in early 2009 causing crude oil to hit bottom at $34/barrel, a stunning 75% drop from the highs of 2008.
  • The stock market slowly began to recover after that, helped by a drop in interest rates around the globe. The US dollar begins to slide again hitting another low in spring 2011.
  • Crude oil was then strengthened by the weakening US currency, hitting an interim high of $114/barrel in the spring of 2011.
  • The US dollar has since been stuck in a sideways trading range, resulting in a corresponding stalemate in the price of crude oil. For the past 2 years, West Texas Intermediate has traded in relatively narrow the range of $85 to $110/barrel.

So where are we now? In the past few months, the US dollar has begun to strengthen again on threats of rate increases by the US Federal Reserve. On Friday, the US Dollar Index hit a 14 month high which has all energy traders asking the question: How high can it go and what does it mean for the price of crude?

To answer this question, let's look at the recent correlation between crude oil and the US Dollar Index:

 
USD-WTI-correlation-plot.jog
 

Not exactly a straight-line correlation but this does give us a good idea of where prices could theoretically be going. The light blue dots represent all data since 2006, while the larger grey dots are more specifically 2014 data. Clearly, price inflation should push the average crude oil prices higher with each passing year. So the probability of going back to $10 oil seems highly unlikely. However, if the recent trend holds true, a 10% increase in the value of the US dollar (to an index value of 93) would theoretically bring crude oil prices into the $60's. A spike back to the range of 120 on the US dollar index could bring us back to the $40 oil level.

So what's the lesson here? Put simply, keep an eye on the US Dollar Index. Although supply/demand curves and weekly inventory numbers do impact oil prices in the short-term, the high level view shows that crude oil prices general follow the strength of the US dollar. Historical data clearly shows that the dollar leads the crude oil market, in most cases by a few months. So if you want to know where the crude oil market is headed, the US dollar is probably your best indicator.

Happy trading! 

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