WTI - An Update On Oil And The Dollar

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Includes: USO
by: Tom Armistead

Summary

Weakness in oil pricing historically correlates extremely well with dollar strength.

The previous relationship seems to have broken down, or at the least is badly stretched.

There are questions of cause and effect, but a return to the normal relationship would imply a large increase in the price of oil.

Back in March last year, I looked at the relationship between the Trade Weighted US Dollar Index and the price of WTI (NYSEARCA:USO), developed a formula with an R2 of .89, and stopped watching the two as they tangoed across the remainder of the year. Here's an update of the chart from the original article:

Click to enlarge

By May 2015 the price of oil was in sync with the formula, and I was holding fine profits on speculative positions in energy stocks. I elected to stay in the game. As we now know, the dollar strengthened, the Saudis pumped flat out, and oil tanked.

Morgan Stanley highlighted the relationship in a note from analysts including Adam Longson, as reported by Bloomberg on 1/11/16. Their take, oil at $20 is a distinct possibility, based on increasing dollar strength. A 5% increase in the dollar could drive oil 10% to 25% lower, in their view.

Under questioning from commenters on my article, I clarified the complex formula developed, noting that a 1% increase in the dollar index correlated with a 3% decrease in the price of oil.

Leveraged?

Logically it seems difficult to justify a situation where the strength of the dollar has such an outsize influence on the price of oil. Possibly the flood of oil strengthens the dollar. Under this interpretation, the Saudis are doing us a big favor, driving up the value of the dollar, reducing the interest rate our government pays on its debt, and easing the burden on our over-taxed consumers.

The Magic Number

In any event, applying the formula, and with the dollar index at 95.19, oil should be at $46.22.

Which Dollar Index?

While the relative strength of the dollar against the Yen, Euro or Pound may be relevant, the Saudis are pumping oil at Russia and Iran, driving their currencies into the ground. Is there an index that relates the dollar to the currencies of oil producers?

Beyond the 95th Percentile

Financial analysis frequently resorts to bell-shaped curve thinking, in spite of the fat tails that occur with stunning regularity. Of course the price of oil is umpteen standard deviations from the mean, whether computed from historical data or from the formula developed for my original article.

I suspect that when you get out to the fat tails, a succession of binary outcomes steps in. It amounts to compounding a series of coin flips. (Shrug).

Investment Reaction

I made a mistake in May and June last year, by not taking profits on my speculative energy investments. Now would not be a good time to correct the error by taking losses.

With that in mind, I'm holding on, although I have made a mental note to close my positions if and when the trade weighted dollar index and the price of WTI are back in sync according to the formula as developed last year.

Disclosure: I am/we are long CRR, CRC, CVEO,XOM,OXY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have disclosed my energy related holdings, all of which will benefit from strength in the price of WTI.