In tracking the back and forth of the oil story, investors have been surprisingly one-sided. By that I don't mean supply side or demand side for oil, but the oil side as a whole. The oil market actually has four sides. The first two are supply and demand for oil, and the other two are supply and demand for dollars.
It is common parlance to call the dollar an unbacked fiat currency, but the truth is that the dollar is de facto backed by oil, not in the sense of being redeemable for a constant and specific amount of oil as for gold during the gold standard, but it is still the only currency with which one can buy oil on the primary market.
That reality ties the price of a dollar to the price of oil, perhaps not as strongly as a bona fide commodity standard, but still very much linked. Practically, this mean that analyzing the supply side and demand side of oil itself are not enough when attempting to analyze the state of the oil market and future price movements. Supply and demand analysis of the dollar is also necessary. There are enough analyses of the supply and demand for oil to read, so here I'll focus on the supply and demand for dollars.
In an extreme case, even if the ongoing oil glut persists, a fall in demand for the dollar can still yield a fast rise in the oil price. The supply of dollars is always expanding, and this time of year is typically when it expands the fastest, so there is little need to take the dollar supply side into account as we can assume it is almost always rising.
Practically the only time it isn't rising, and the one thing that needs to be tracked on the dollar supply side is what happens around mid to late April. A look at the latest Money Stock Measures report published by the Federal Reserve shows the weekly average dollar supply at $12,649.2 billion, or $12.65 trillion in table 2, bottom row final column. A look at last year's report at this time shows a peak on April 6, 2015 that rapidly fell 2.1% by April 27, and struggled to surpass that peak until September 7 when the weekly average dollar supply reached $12.156 trillion (again table two at link). The very same thing happened in 2014 when the weekly average supply peaked on April 14, dropped 1.6% by April 28, and did not consistently break that peak until September 1. The same pattern can be seen in 2013 and almost every other year. Here are the relevant charts for the last three years.
Whether it's tax day that accounts for this annual drop or something else I don't know, but as price inflation is picking up (in other words the demand to hold dollars in cash is already dropping on the consumer level) it will become more and more important to track the annual dollar supply drop as we head into late April. If it either doesn't happen or the supply quickly recovers by May or June (it typically takes until late August), that could spell a major increase in further price inflation and a rise in the price of oil with the entire commodity complex, regardless of the supply and demand picture for oil or commodities themselves.
The other factor that needs to be watched carefully is the demand side of the dollar, and that is velocity of money circulation, which basically measures the frequency with which a dollar changes hands. That is roughly an inverse measurement of the demand to hold dollars in cash. This, more than any other chart in my opinion, is really the dollar's saving grace since 2008.
Money velocity has fallen nearly every single quarter since Q3 2010, after an initial dive in 2008. Looking at the chart since 1959 when measurements first began, first off, money velocity has never been so low, meaning the demand to hold cash has never been so high. The second thing to notice is that velocity has never fallen so precipitously in non-recession times. This makes the current relatively low price inflation a very loaded spring. Dollar supply is higher than ever at $12.6 trillion, but demand for dollars on the consumer side is also higher than ever. The dollar supply will not fall significantly, which is one of the only certainties left in today's markets. If dollar demand falls even to 2010 levels let alone 1997 levels, price inflation could become a serious problem.
Keep in mind that record inflation in the modern era in the United States occurred in 1980, when interest rates near 20% were required to quell it, and money velocity, the rough inverse of dollar demand, was 26% higher than it is now.
That means a climb of 26% in money velocity could possibly put us back at record price inflation. A similar climb of 20% in money velocity did in fact happen between 1991 and 1995, just to give an idea of what is possible, though that was during an extreme productivity boom thanks to the Internet so the effect on actual prices was muted.
Swinging back to oil, it is a fool's errand to make the case that either the dollar or oil leads the dance between the two. Does falling oil lead a rising dollar or vice versa? It's most likely a combination, given that these markets are made up of billions of individual decisions by market actors over time. What we do know though are these 2 key things:
1) Never has the oil price been so low relative to the dollar supply
2) Never has the demand to hold dollars been so high
Therefore, whichever metric you want to track as the lead in the dance or both, the dollar/oil markets are both loaded springs waiting for a trigger to set them in opposite directions. Oil has already started to recover without any fundamental change in the oil supply and demand dynamics. It's either a short technical bounce restricted to oil, or something is happening with the dollar, which would be systemic.
Watch dollar demand and supply as we head into summer. If velocity ticks up and supply stays steady from April to July when it typically falls slightly, it could prove very bearish for the dollar and very bullish for commodity markets.
Disclosure: I am/we are long CORR, POT.
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.