WHY OIL'S NEXT MOVE DEPENDS ON THE FED
The greatest risk to prices in the months ahead is the U.S. dollar, says Martin Pelletier
It has been a great year for commodities and especially crude oil prices, which have rebounded 96 per cent off their January lows. The majority of oil’s gains were posted in March and April, with a flat but volatile environment since then leaving many wondering if we have finally reached an inflection point.
Not surprisingly, there is a lot of trepidation among investors wondering how to play the sector going forward, especially when it comes to oil and gas companies currently facing bank reviews.
The greatest fear is that we will see a repeat of last year, when oil prices peaked before collapsing back to near US$26 per barrel.
In our opinion, while history does rhyme it rarely does so in such a short period. This is why it is important to expand analysis to a period encompassing a number of full-market cycles.
For example, there is little doubt that after every major correction in oil prices in the past 30 years, there has been a recovery that is equal or larger in magnitude.
Three out of four times, this recovery didn’t end until the price had rocketed back 240 per cent to 275 per cent from its lows. The one time it didn’t, in the mid-’90s, it recovered 90 per cent thanks in part to the U.S. Federal Reserve aggressively hiking interest rates.
Looking ahead we see a number of factors that could have a material impact on oil prices, with likely more upside than downside if the fundamentals are allowed to play out without central bank interference.
These fundamentals include a world market that is much closer to balance thanks to production curtailments among U.S. shale producers — they have cut about 900,000 barrels per day from their 2015 peak — and recent supply disruptions in Canada, Nigeria, Iraq, Libya, Colombia, Venezuela and Argentina totalling 3.6 million barrels per day, according to the EIA.
That said, this could prove to be short-lived as these disruptions come back on line over the next few months.
It is imperative that U.S. shale production continues to decline at the same time the IEA’s forecast of an additional 1.3 million barrels per day of global incremental demand materializes in the second half of 2016.
The greatest risk to oil prices in coming months, in our opinion, is the U.S. dollar in which oil prices are denominated and traded.
The problem is that the two have a negative correlation and have been battling it out over the past two months as speculators are placing their bets on whether the Fed will hike rates or not.
It certainly doesn’t help that the Fed and its members, such as St. Louis Fed president James Bullard, have been fuelling this uncertainty.
The bottom line is that we think the upside to oil prices will quickly dissipate should the Fed commence rate hikes not unlike what happened in the mid-1990s.
Finally, global investors have piled into U.S. treasuries chasing yield thanks to a global government bond environment that has turned flat to negative. While we don’t see this situation changing much, it creates a real challenge for the Fed and therefore could result in more of a dovish position going forward, which is good for oil prices.
In the near-term, perhaps there could be some further support to the oil price and downside to the U.S. dollar should the U.K. choose to remain in the European Union via its referendum this Thursday.