Oil - Currency Risk In The Near Term, Upside Long Term

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Summary

Oil inventories are still elevated and are far away from a shortage.

An appreciating U.S. dollar and rising U.S. interest rates could weigh on prices.

Lack of global oil investment because of low prices long term could lead to a supply shortfall and significant oil price increases.

I believe oil prices are going to face a currency headwind over the next 6 to 18 months. Oil inventories are still elevated. Supply and demand will rebalance but it will take time for inventories to come down. In the interim, macro and currency moves will largely drive oil prices in my opinion.

I think many markets are being influenced by Federal Reserve policy expectations. This is why the Fed Fund futures rate hike probabilities have become so popular. I think there is a degree of complacency regarding the path of monetary policy and economic data in the U.S. If the data picks up then the Federal Reserve will raise rates quicker than markets are currently pricing in. I expect one rate hike this year potentially in September and multiple in 2017. According to CME Group, markets are only assigning a 41.8% probability of one interest rate move by June 2017. I think this is overly bearish. There is only a 15% probability of a rate hike in September and 38% for December.

I think it is highly unlikely for the Fed to undershoot interest rate expectations at this point. The U.S. economic data could reasonably improve and the economy may diverge from the rest of the world. This would lead to a strengthening dollar as the Fed responds to an improving U.S. economy while most of the other central banks ease further.

Currency fluctuations will have a large impact on oil prices in the coming months. The majority of oil's price decline coincided with a significant strengthening of the USD. I expect the dollar to launch another phase higher. It will take time to deplete inventories sufficiently for prices to rise. This is not a near term event in my view.

I believe the U.S. economy is on an inflationary path long term that will coincide with the a major rise in oil prices and a sharp depreciation of the USD. In the near term, it would involve an improving U.S. economy, higher growth, moderately higher inflation, rising wage growth and further improvement in the labor market. This would support the Fed raising rates faster than markets anticipate leading to bond yields in the U.S. moving higher and the dollar appreciating versus most currencies. This will likely push oil lower unless inventories begin falling at a rapid pace.

In the next three years I believe oil could reach approximately $90 a barrel. Global investment in oil is declining because of a prolonged period of low prices. This will reduce future supply. Many central banks including in Japan and Europe are running pro-inflationary and pro-growth policies. The Fed is behind the curve. Low prices stimulate demand growth, so I am very optimistic on demand over the long term and I think supply shortfalls and lack of investment will lead to a major drop in inventories at some point. I don't think a significant rebound in oil prices will occur over the next 6 to 12 months.

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The Fed is behind the curve because it has set the economy up for potential high inflation, ignored the recovery thus far and has delayed raising rates. The data was previously supportive of a rate hike but the Fed has to taper QE first and communicate to markets their intent to raise rates. Now with the economy going through a soft stretch they have chosen to delay and hold rates steady. They will follow through though if the data improves.

The scenario for high inflation is a result of the effect of QE on reserves in the banking system, prolonged low rates, strong credit growth, and repaired debt to income ratios and balance sheets. Household debt to income ratios are at 30 year lows. As inflation picks up the Fed may have a difficult time reigning it in. On a path towards inflation, it would involve an improving U.S. economy. It may be counterintuitive that an improving U.S. economy could be bearish for oil, but this would allow the dollar (NYSEARCA:UUP) (NYSEARCA:USDU) to appreciate and with inventories elevated could have a negative effect on oil (NYSEARCA:USO) (NYSEARCA:XLE) prices. Long term, high U.S. inflation coinciding with a rise in oil prices could cause a major fall in the U.S. dollar, though I think in the near term dollar strength and muted inflation/oil prices is the most likely outcome.

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