Higher Oil Prices Face Strong Headwinds

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Includes: BNO, DBO, DNO, DTO, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO
by: David I. Templeton, CFA

Since March 27 spot WTI crude oil has moved higher by 11% increasing from $47.02/bbl to $52.25/bbl. This rise in price has occurred during a period when crude inventory levels in the U.S. continue to rise. This increase in crude inventory levels is taking place at a time when the drilling rig count continues to increase as well. Historically, an increase in rig count has coincided with higher crude prices; however, inventory levels were much lower in the past when the rig count began to rise.

Oil prices have a tendency to rise during the summer months as summer travel increases. Potentially working against a seasonal oil price boost is the direction of interest rates in the U.S. The Fed has already increased short term rates three times from near zero. The Fed meets again in May then in June. The odds of an interest rate hike in May are in the single digits; however, the odds of a rate hike in June are currently near 70%.

Higher interest rates have a strengthening affect on the U.S. dollar, which in turn places downward pressure on oil prices. The long term correlation between the trade weighted dollar and interest rates is .72. The first chart below shows the longer term dollar/rate comparison and the second chart is the same comparison using a shorter time frame. It is clear these two variables have a strong correlation to each other.

The following chart compares the dollar to the price of WTI crude oil. The correlation between the dollar and crude oil prices is negative .88, so as the dollar increases, oil prices have a strong tendency to fall.

With crude inventory levels in the U.S. at record levels, a rig count that continues to move higher and a Federal Reserve in an increasing interest rate mode, it seems higher oil prices face some stiff headwinds. Absent the potential negatives lower oil prices could have on the energy sector, the consumer would be a certain beneficiary. With the consumer needing to spend less on energy, additional dollars in their pocket could translate into other areas of the economy; thus boosting economic activity more broadly.

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