The geopolitical backdrop and news flow is creating ripples across commodity markets, and giving the rebound in crude oil a boost as tensions rise in the Middle East. But is it time to step up bullishness on the oil price? …or has the meat of the move already been eaten? I look at a couple of near term downside risks for oil, which as a minimum will present headwinds and likely make oil bulls think twice about jumping on the momentum bandwagon.
The key takeaways on the risk outlook for crude oil prices are:
-Typically the oil price moves inversely with the US dollar.
-Thus when you get a scenario of a stronger US dollar, with potential upside to come, it means headwinds for oil.
-At the same time, long oil looks like a crowded trade, meaning downside risks are elevated.
1. Crude Oil Price vs the US Dollar: While there have been times where the US dollar and the crude oil price decouple, the typical relationship is that as the dollar strengthens, the crude oil price weakens. There's a few good reasons for this: firstly, WTI crude oil is priced in US dollars (so there is a simple exchange rate effect), second, a stronger US dollar can often have a tightening effect on financial conditions domestically and abroad (thereby negatively impacting demand for oil), and thirdly a stronger US dollar implies a higher price of oil for those whose currencies are weakening against the US dollar (making crude oil appear more expensive to them).
The chart below shows this relationship between the change in oil prices and the change in the US dollar (which has been inverted, in line with the economic logic described above). The extension of the red line past that blue bar is simply what the YoY (year on year) change in the US dollar would look like if you just held the current level of the US dollar index (DXY) unchanged from now until the end of the year. As I noted elsewhere, my view is there is actually further upside risk for the US dollar, so this potential headwind for oil prices could get worse in the coming months.
