The U.S. Dollar And Crude Oil - Has The Time Come For A Regime Change?

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The U.S. Dollar And Crude Oil - Has

The Time Come For A Regime
Change?
Nov. 7, 2017 7:29 AM ET | Includes: BNO, DBO, DNO, DTO, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, …

Blue Quadrant Capital Management Follow

Long/short equity, Deep Value, hedge fund manager, macro

Blue Quadrant .cls-1{fill:#024999;} (305 followers)

Summary

The US Dollar has traditionally been loosely inversely correlated to

movements in the oil price over medium to longer-term time periods.

As the largest consumer and importer of crude oil, there was a sound
fundamental reason for this relationship.

However, with the rise in US shale oil production and LNG exports, the
US's net energy import balance has declined significantly.

The energy trade deficit will likely narrow even further, suggesting that
other major developed economies are now far more sensitive to a
sustained rise in energy prices.

This suggests that an important regime change in global financial markets

could be coming, where the US Dollar becomes increasingly positively
correlated with oil and global energy prices.

In this article we discuss the relationship between the US Dollar

(NYSEARCA:UUP) and crude oil (NYSEARCA:USO), arguably the most
important currency and commodity in the global economy today. More
specifically, we make the argument that the fundamental backdrop that has
driven the relationship between these two variables in the past has changed
dramatically over the past five years, potentially portending a coming seismic
regime change. We conclude by briefly outlining some of the key risks or fault-
lines such a regime change could unearth.

Traditionally, oil and the US Dollar have been negatively correlated over
extended periods of time. As the chart of the two variables shows below,
although this relationship does not necessarily hold on a month to month
basis, protracted periods of rising oil prices has often been associated with a
weaker USD. Due to the large spike in oil prices between 2006 and 2008, we
have broken up the period from 1980 into two charts, the first one depicting
the two variables between 1980 and 2002 and the second from 2002 to
October 2017.

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The U.S. Dollar And Crude Oil - Has The Time Come For A Regime Change? | Seeking Alpha

Source: St Louis Federal Reserve Database

As we can see, the USD appreciated quite significantly between 1980 and
1985, a period which saw oil prices decline by more than 60%. The USD then
entered a new weakening phase from 1985 to 1990, where oil prices
rebounded, peaking in 1990 with the invasion of Kuwait by Saddam Hussein.
Between 1990 and 1995 both oil and the USD traded largely sideways. From
1995 to 2001 the USD strengthened, a period in which the price of crude
collapsed down to $10 a barrel in 1998 before rebounding quite sharply. The
period between 1999 and 2002 is interesting in that the USD remained
reasonably firm, while the oil price actually rose by almost threefold off its
December 1998 lows. Part of the deviation in the relationship is likely a
function of the fact that the oil price had collapsed so sharply between 1997
and 1998 and was therefore significantly oversold. Furthermore, the OPEC
cartel also instituted a series of coordinated supply cuts that helped the oil
price recover quite sharply in 1999.

If we look at the time period between 2003 and 2017, we can see a similar
inverse relationship holds, although given the large relative spike in oil prices,
the amplitude or “beta” for a change in the oil price relative to the USD is
much greater.

Source: St Louis Federal Reserve Database

As we can see above, the oil price appreciated sharply between 2003 and
2008, a period of sustained USD weakness. Since 2009, the USD first traded

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The U.S. Dollar And Crude Oil - Has The Time Come For A Regime Change? | Seeking Alpha

sideways then appreciated back to its 2002 levels on a broad trade-weighted

basis. Following the crash in oil prices during late 2008 and early 2009, crude
oil did recover back to $100 per barrel, remaining at this level until 2014
before collapsing in price during 2015 and 2016. Although the USD had
already embarked on a new appreciating trend from 2009, the USD bull
market only really started to accelerate in 2014, just as crude oil prices
started to decline in earnest.

From 2016 onwards we have had a relatively stable USD in tandem with an
apparent nascent recovery in oil prices. On balance, we can therefore say very
loosely that the USD has been inversely correlated to oil prices. Indeed, the
correlation coefficient for the two variables over this time is negative
(implying an inverse relationship) albeit only at 0.21.

What is the fundamental reason for this inverse relationship?

There are two key factors which potentially explain this inverse relationship.
Firstly, ever since US conventional oil production peaked in the early 1970s,
the US’s consumption of foreign or imported oil has grown. In fact, as the
chart from the EIA below shows, net US oil imports reached a record 13mn
barrels a day in 2005. As a result, the US’s net energy deficit grew
substantially between 1970 and 2005, making the country’s trade balance
extraordinarily vulnerable to rising energy prices and specifically oil prices.

A second reason is the historical role that the US’s Federal Reserve has played
as the de facto global monetary policy hegemon. Periods of falling interest
rates or accommodative monetary policy in the US typically led to a fall in the
USD’s value relative to other major currencies. However, falling interest rates
also typically foreshadowed a recovery or pickup in US economic activity,
which, given the US economy’s large global share of output and hence
commodity demand, would also drive up commodity prices in anticipation of
higher demand. Thus was borne the broader inverse relationship between the
USD and commodities in general, not just oil in isolation.

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The U.S. Dollar And Crude Oil - Has The Time Come For A Regime Change? | Seeking Alpha

But do these fundamental factors still hold today?

Well, this is where things get interesting in our opinion. As the EIA chart above
also shows, the shale revolution and rebound in domestic US oil production
has consequently led to a renewed and marked decline in the country’s net oil
imports. From the aforementioned peak of roughly 13mn barrels per day in
2005, net oil imports have declined to an average of around 4mn barrels per
day (three-month average for June, July August 2017).

Given the further anticipated growth in US oil production and exports as well
as natural gas or LNG exports, it is not inconceivable that the US economy
may eventually cease to be a net importer of energy all together. The
elimination of the country’s net energy deficit is something of real significance
to the global economy and cannot be overemphasized enough. As can be seen
in the table below, countries traditionally seen as less “energy intensive” and
whose currencies therefore appreciated against the USD during times of rising
energy prices are now much larger net energy importers relative to where the
US stands today (let alone potentially in two or three years time).

As the table below shows, if we focus on total net energy imports including
gas and coal, the US’s level of GDP generated per imported energy unit (oil
equivalent tonne) is already much higher than any other major economy. This
ratio will only rise further in the next few years, and will likely deteriorate
significantly for countries such as China and India assuming their consumption
of energy will continue to grow at roughly the same pace as domestic demand.

Source: Enerdata

What this really suggests is that in a rising price environment for energy
commodities, the USD should really appreciate on a broad trade-weighted
basis. Especially vulnerable are currencies tied to emerging market economies
that are large net importers of energy, such as India, Turkey and South Africa.
In the past, these countries would have had some relief from the pressure of
rising energy imports on their currencies from a weaker USD. If we are now
entering a new world order or regime change which sees the USD increasingly
positively correlated to global energy prices, these emerging economies with
large energy net imports could be especially at risk of a large and potentially
destabilising devaluation in their currencies at some point.

As it pertains to the second factor or the USD relationship with commodity

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The U.S. Dollar And Crude Oil - Has The Time Come For A Regime Change? | Seeking Alpha

prices more broadly, this may still hold true to some extent. However, even
here, China is now the predominant consumer of a range of key commodities
including iron ore and copper. Therefore, the price for these commodities
should become far more tied to economic conditions in China as opposed to
the US and as such, even disconnected from shifts in US monetary policy or
US economic activity. It is quite possible that even with the backdrop of a
stronger US economy, should the Chinese economy weaken substantially (or
more specifically fixed investment spending), certain commodities could still
come under significant pressure.

How important is this potential regime change?

We think it is crucially important and may ultimately end up triggering the

next financial crisis. This is particularly relevant in the event that energy prices
spike due to some kind of geopolitical event, in which case the USD safe-
haven status could become even more compelling in this new “energy” world
order. Rising energy prices in the past have been an important factor leading
to a widening the US current account deficit, and by implication an increase in
global USD liquidity. This increase in global USD liquidity helped to weaken the
USD and ultimately support a countervailing easing in global monetary
conditions. This helped net energy importers absorb the cost of the rise in
energy prices and therefore ‘soften’ the blow on their economies.

However, if the US current account now becomes ‘unresponsive’ to changes in

global energy prices and the USD starts to become positively correlated with
energy prices, then net energy importers are now likely to face a “double
whammy” so to speak. As the USD strengthens, it will exacerbate the
inflationary pressures in their own economy ultimately leading to tighter, not
looser monetary conditions. As we have already mentioned, this dynamic could
become quite acute in the case of smaller emerging economies with large
imported energy requirements, as well as those countries with large external
USD-denominated debt.

We are also entering an era where the US labour market is probably as tight
as it has been at any time over the past 60 years, while US households remain
less leveraged than at any time over the past 30 years. In fact, the positive
impulse (on economic activity) of an increase in energy prices on oil-producing
states within the US, taken together with these aforementioned factors, means
that the US is probably in far better shape today to handle higher energy
prices coupled with a further appreciation in the USD than at any time in the
past 50 years.

As such, those that would expect US monetary policy to quickly change

direction in the event that a positive correlation between the USD and higher
energy prices starts to gain traction could end up being surprised at how high
the USD would have to go before it would impact or change the trajectory of
US monetary policy. In fact, one could easily make the argument that the
global economy will break first before the US economy succumbs to the twin
forces of an appreciating currency and higher energy prices.

About this article: Expand

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The U.S. Dollar And Crude Oil - Has The Time Come For A Regime Change? | Seeking Alpha

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