Conditional Risk Analysis

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Includes: BNO, DAC, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, UDN, USDU, USL, USO, UUP, UWTI
by: Evans Osemwegie

Summary

Prices do not move markets.

Conditions move markets.

We should expect a significant increase in the price of oil this year.

Summary

In this article, I seek to make the case that we should see a significant upswing in crude oil prices as well as in general inflation this year.

It is also my view that we will see a significant weakening of the dollar especially against the euro as the Eurozone will see significant economic growth.

The reason why I believe this is the case is fundamentally the increasing demand for oil around the world coupled with a weaker dollar.

The beginning of 2016 has been a very interesting year as far the financial markets are concerned with the slowdown in China and a pessimistic outlook in the global market.

While we have seen continual declines in the market, it is important that we put the market action in its correct context because it is important to realize that prices do not move markets but conditions move markets and in analysing the risk exposure of a market position, rather than look at prices, we must look at the market conditions to determine how this will affect the market.

The downturn we see in the crude oil market started on about the 28th June 2014 and has continued up to today.

There have been many suggestions as to what happened and why it happened but the reality was that a confluence of factors including concerns about Fed tapering, inflation concerns, global economic concerns, increased supply and falling demand due to a unsustainable high market price for crude oil suggested to the insiders that it was time to begin to sell oil and the initial sales will then have triggered more sales and this will result in the market falling and this falling has continued up to today.

Incidentally, I believe that going into the spring, we will begin to see a very aggressive rise in the price of crude.

Click to enlarge

If you look at this chart, you will see how demand has climbed with supply up to the point that more recently, it is almost equal, this is at a time when production is falling particularly in the USA and the amount in storage is beginning to fall.

There is a market expression that says that 'the only cure to low prices is low prices', every businessman or economist know that the cheaper something becomes, the more widely it is used and this is why in times of low inflation, money is made cheaper by the lowering of interest rates.

This is exactly the same principle for oil because the extended season of low prices have created novel conditions in the market whereby consumers have become used to cheaper gasoline and use more of it as have companies and this has been one of the factors for the buoyant stock market we saw last year.

If one was to draw a chart of oil prices and compare it with either the Dow Jones, S&P 500, FTSE 100 or even the Nikkei 225, one will see a significant divergence between them in that as oil has fallen, it has improved their profitability significantly.

The correlation between oil prices and stocks is quite strong but nevertheless, correlation should be seen as a dynamic and not a static process as sometimes assets may move together under certain market conditions and in other cases, one asset may lead the other.

An example is this gold, dollar and oil chart and by looking at this chart, one is reminded of the benefit of using correlations for one's investment benefit.

There are many ways one can conceptualize the market, some see it as one big blob, others see it as a mob, other say it is a perfect machine.

I choose to see it as a system of weights and pulleys whereby when one asset class moves, it forces all of the others to move as well because there are no vacuums in the market, whenever an asset class for example the dollar rises, this will drive down for dollar denominated assets as well as export and import activity in dollar as the market will seek an equilibrium so there is a price at which buyers and sellers agree.

If the product is crude oil, then this drives the crude oil prices lower because the buyers understands that he/she cannot buy as much crude oil as they could previously and this drives demand lower.

These concepts may be obvious but what is not so obvious but yet even more significant is the change of behaviour of these companies because their success has changed them and caused them to adapt their business model in light of current conditions.

Many oil companies have become much leaner and have put off necessary expansion and exploration investment plans, so when taken together, it becomes clear without realizing it, we have all become used to a world of cheap oil and our future expectations may not really have factored in or prepared for an increase in oil prices in 2016.

As a result of this, we now have a perfect storm of rising demand falling supply which will push oil prices significantly higher as we enter into spring and the summer driving season.

This rise will have a number of other effects as we are likely to see lower earnings for quarterly reports in Q3 AND Q4 2016.

This should also drive the prices of agricultural commodities and food higher which will result in a substantial surprise for the Central Banks in the form of higher than normal inflation rate especially with the large volume of money in the global markets.

The effects of this will be seen in every asset class including emerging market securities but I believe where we will see the most effect will be in the price of the US dollar as it will begin to weaken both through economic pressures and Fed assistance but this fall will further increase demand for commodities globally and act as a counter against the increased commodities prices.

The fall in the US dollar will be seen especially clearly in its relationship to the euro. We will begin to see increasing inflation and interest rates in the Eurozone not simply because of the rise of oil prices and the fall in the dollar but a substantial increase in demand across the Eurozone is due to the large wave of immigrants coming from the Middle East, notwithstanding the social concerns about this mass migration, it will create demand in the Eurozone which will result in further rises in production.

All of these factors taken together points to a fundamental change in the market whereby previously, we were in a market driven by crude oil throughout 2015 but towards the end of January 2016, there was a subtle difference in that the market is becoming increasingly driven by the dollar.

Based on all of the above, I will begin to sell the dollar against the euro, buy commodities companies and shipping companies like Danaos Corporation (NYSE:DAC) as these will go higher particularly as I believe the bears speaking about China are over exaggerating as the consumers and thus the demand is still there.

Finally, I will sell the shorter term US fixed income securities and buy the medium term fixed income securities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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