Schork Oil Outlook: $74+ Crude is Overpriced
ENERGY PRICES WERE WEAK ON MONDAY… the entire complex ended the month on an ugly note. However, with London closed for the Summer Bank Holiday and New York closed next Monday for the Labor Day Holiday, we will not read too much into this week’s price path.
The Schork Report last looked at the dollar crude correlation in July, when crude was weakening and corporations were about to release their annual results. In our 16th July report, we concluded that:
“We could be looking at moderate strength from crude throughout July [and] further relative weakness in crude would be a very significant outlier… …We’re at the start of the U.S. earnings season so if a lot of companies report good news we could see the dollar fall, that would also indicate strong consumer/factory demand and an uptick in crude prices.”
Whether coincidence or causality, a strong earnings season and a recovery in crude prices both took place, and, on cue, the dollar fell. Now that earnings season is over and traders return to examining the fundamentals (or, at least, stop ignoring them completely) can we still count on the dollar and crude to move in opposite directions?
On CNBC.com now: Slideshow: The 10 Hottest Commodities of 2009
Historically, September has seen a 2.22% increase in crude prices, while the DXY index (the dollar weighted against a basket of other currencies) has fallen 0.75%. The DXY/CL ratio falls on average by 1.94% implying strength in crude relative to DXY over September. Interestingly, September’s correlation between the two assets has been negative during the years 2004-08 and positive during the years 1999-03 implying a sea change in the way traders are looking at the commodities markets. Whereas previously the dollar and crude were lumped together as alternative investments, the last few years have seen more discerning investors focus on crude as an inflation hedge. Back on topic, more recently correlation is strongest when crude prices change the most, with a correlation of -0.69 when crude prices rose 12.82% in September 2004 and -0.83 when crude rose 8.8% in 2007.
Those looking to take advantage of this trade would hope that prices this month follow the trend set by September 2007, as highlighted in the graph in today’s issue of The Schork Report. We chose 2007 due to the similar reference points for both contracts (prices of both commodities at the close of August 2007 and 2009 differed by less than $2), bearish sentiment on the dollar and bullish favour for crude. The most interesting point to take away should be the dollar’s relative stability. Crude prices in Sept ’07 were almost three times as volatile, with a standard deviation of $2.44 as compared to $0.87 for the DXY index. That explains why a 3.91% drop in the DXY led to an 8.8% increase in crude prices. In August this year we’ve seen an even stronger relationship, as crude prices rose by 5% over the last two weeks while the dollar slumped 1.17%. Following the ‘07 regression, last week’s DXY index value of $78.366 should have led to crude prices of $74.9263 which the bulls got last week (74.95 electronic, 75 on the Floor) before they lost confidence.
Fundamentally, $74+ is overpriced, but it was overpriced in 2007 too and that didn’t hold back the market. If the dollar follows the 4% drop it saw in September 2007 and the bulls jump on the DXY/Crude relationship, crude prices have a wide open window for $77.699 and above before the month is through.
Stephen Schork is the Editor of, "The Schork Report"and has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.