Schork Oil Outlook: Crude Mirrors Dollar—But Up or Down?

Despite strong fundamentals and the fact that we are losing 400,000 gallons (we think) of crude oil every day in the Gulf Coast, traders have been pushing the liquids lower on the back of the almighty dollar. It was exactly two weeks ago today that crude oil prices peaked at $86.19. Since then they have fallen 18.7% to $70.08 as of last night. Meanwhile the dollar has rallied 6.4% from €0.758 to €0.807 over the same period.

As today’s Chart of the Day in today’s issue of The Schork Reportillustrates, the correlation coefficient between the two securities has strengthened to - 0.64, which means that 64.3% of crude oil’s drop can be explained by the strength in the dollar (and vice versa).

But as the chart also shows, this was not always the case. As close as April 13th, the correlation co-efficient stood at a positive 0.620, i.e. 62.0% of crude oil’s rise could be explained by strength in the dollar! In fact, historically the correlation varies from highs of 0.888 to lows of - 0.971.

So what causes this wide range? Intuitively we expect the relationship to be negative — crude is a dollar denominated currency, so a strong dollar makes crude oil more expensive in terms of other currencies. To counteract this drop in demand, the price of crude oil falls, returning demand to its equilibrium value. In theory.

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In reality, we have seen large spreads of time where the dollar and crude rise or fall in tandem. Between May and June 2008 the correlation averaged 0.233. Between late December 2008 and February 2009 correlation averaged a positive 0.458. Both periods marked a gain in both the dollar and crude oil as speculators fuelled the market higher. Correlation returned to an inverse relationship after the highlighted periods, the difference is that in July 2008 it was crude that fell while the dollar rose, whereas in March 2009 it was crude oil which rose while the dollar fell.

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Now that correlation is negative, we can expect it to hold that way - the average length of time with positive correlation is 28 days, the average length of time for negative correlation is 102 days. The question now becomes: Do we expect crude to fall while the dollar rises – a la 2008, or do we expect the dollar to drop while crude oil recovers – a la early 2009?

Fundamentally, the latter prevails. American companies reported strong earnings through the last several quarters, and even the ones that lagged are beginning to pick up — GM is expected to report its first quarterly gain profit since Q2 2007. Keep in mind this was a company on the verge of bankruptcy almost a year ago. Strong earnings will lead to a weaker dollar from a fiscal standpoint, but will also bring back investor confidence. A more confident investor is a more risky investor, so expect money to flow away from the dollar, currently a “safe haven” back towards crude oil.

The latest advance retail sales data is bullish for the domestic recovery. Total retail and food services sales for April grew 0.4% from March, and are now 8.8% above the same time last year and 4.3% above the 2004-08 timestep. Sales of motor vehicles and parts are up 0.5% month-on-month and a huge 15.1% higher year-on-year. In comparison, April 2009 saw sales 22.0% lower than 2008 which should highlight how starkly conditions have improved (and how bad they once were).

April 2010’s numbers are more bullish. Gasoline station receipts were up 0.5% month on month following a 1.8% increase in the national average gasoline price, from $2.851 to $2.901. Consumers are becoming more willing and able to pay higher prices at the pump.

This is important considering that in the mid to long term (or even the short term if Nymex WTI bounces back), prices at the pump will go up. There is no doubt that demand destruction is taking place – every time someone replaces their Range Rover with a Prius it is 20-30MPG which will never come back to the grid. But in relative terms, we are spending less on gasoline than we are on our HDTV’s and iPads. Effectively, gasoline is cheap, and as demand comes back and prices on the Nymex recover, it will become more and more expensive.

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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.