Dollar-Neutral Crude Oil

Adam Hamilton     April 25, 2008     2975 Words


Crude oil is one of the hottest commodities on the planet these days.  Almost without respite, it has surged 16% in April alone!  It closed at new all-time record highs on 8 of the past 11 trading days.  Pushing $120 per barrel now, the fabled $100 price point that the markets feared for so many years now seems modest.


Commodities bulls have been long oil and oil stocks for many years now, so oilís strength isnít too surprising.  Naturally we attribute its powerful advance to a global supply and demand imbalance.  Oil demand is simply growing a lot faster than oil supply, so higher prices are the only way to retard demand and accelerate production until a new equilibrium price is reached.


But Wall Street, with its perpetual anti-commodities bias, continues to try and dance around the ironclad fundamental basis for this oil bull.  In sectors it doesnít like, it tries to rationalize away fundamentals in order to attribute advances to more ephemeral factors.  So now it claims speculators and the US dollar are almost exclusively driving oil.


If speculators are to blame, oil should have witnessed a sharp correction after it hit the most overbought levels of its entire bull in early November.  Yet instead of plunging from the high $90s, oil merely consolidated sideways at these high levels.  It formed a base between $87 and $100 from which its latest rally launched.  Speculative fervor is short-lived, it alone cannot maintain record prices for 6 months running.


Speculators buy in fast, driving vertical moves.  And they leave even faster, sparking sharp plunges from highs.  The latter didnít happen in oil, suggesting a global supply-and-demand imbalance is a far larger factor driving its extraordinary strength over the past 8 months than speculator greed.  So Wall Streetís latest avoidance strategy is to blame the dollar, claiming oilís strength is mainly the result of a weak dollar.


Today in mainstream market analysis, it is increasingly rare to see oil mentioned without the struggling US dollar being credited for oilís strength in the very next sentence.  While the weak dollar is definitely a factor, overemphasizing its role is misleading traders.  If traders believe the Wall Street party line, then they expect oilís strength to fade whenever the dollar rallies.  This could really adversely affect their future gains.


If fundamentals are oilís primary driver, its bull market will persist for many years to come until some sort of new equilibrium consumption and production level is reached that fully reflects the ascent of Asia.  But if the dollar is oilís primary driver, then its bull is largely over as soon as this dollar bear ends.  Obviously prudent investment strategies going forward would vary considerably between these two different worldviews.


So as a long-term investor in energy stocks, I wanted to gain a better understanding of just how big the US dollarís role has been in oilís bull.  With the Fed actively trying to destroy the dollarís international purchasing power, everything we import into the States has to become more expensive.  So the dollar is definitely a factor.  But real fundamental oil imbalances exist too, so the dollar certainly isnít the only factor.


To do this research, I wanted to render oil in dollar-neutral terms.  What would this oil bull look like if the ongoing US dollar bear was somehow extracted out of oil prices?  I thought about doing this mathematically, creating a hypothetical oil price based on a flat US Dollar Index.  But such a construct doesnít reflect anything relevant in the real world.  So instead I charted oil in key alternate currencies.


The first is the euro, the leading contender to usurp the dollarís long reign as the worldís reserve currency.  Across the globe, everyone from central banks to street vendors happily accepts euros.  As an added bonus, the euro now dominates the benchmark 35-year-old USDX.  The euro accounts for 57.6% of this indexís entire weight today!  The Japanese yen is a distant second at just 13.6%.  Thus looking at oil priced in euros is essentially USDX-neutral because the euro is the USDX.


The second alternate currency is the worldís oldest and best, gold.  Gold maintains its intrinsic value over centuries regardless of what central banks are doing to debase their own fragile fiat currencies.  Gold is also highly sought-after by the major oil-exporting countries, so they almost certainly monitor oil priced in gold to see what kind of real value they are getting for their scarce depleting resource.  Oil priced in gold is fiat-currency neutral.


On these charts, oil priced in euros and gold with the usual accompanying technicals are rendered on the right axes.  Underneath this, the familiar US dollar oil price is rendered in red and tied to the left axes.  At 5 major bull highs in USD oil, oilís bull-to-date gains in both the alternate currency and US dollars are noted, along with their ratio.  All axes are zeroed to ensure the relative slopes are visually distortion-free.



Oil is also making new all-time highs in euros today, but they arenít anywhere near as extreme as those in dollars.  Between the major USD oil highs in July 2006 (number 4 above) and today, USD oil has rallied 53.5%.  But euro oilís simultaneous top-to-top gain is a far-more-modest 22.1%.  This yields a ratio of 0.41x, suggesting that just four-tenths of oilís USD gains since July 2006 were driven by global fundamentals.


But realize this was over an exceptionally weak period even for this dollar bear, so we shouldnít jump to conclusions from one comparison.  Instead itís best to start at the beginning.  Back in November 2001, oil bottomed under $18 and kicked off our current secular bull run.  The USDX was near secular highs then, challenging 120, so oil was relatively cheap for the US.  The parallel bottom was much higher in euro terms, just under Ä20.


But as the US dollar bear started in earnest in early 2002, dollar oil began to rise faster than euro oil.  By the time oil reached its first major bull high in March 2003 in the pre-Iraq-invasion spike, euro oil was only up 0.65x as far as dollar oilís 117%.  Euro oilís initial uptrend was more modest too, nowhere near as steep as dollar oilís.  And as euro oilís 200dma shows, it was essentially flat from 2002 to mid-2004 during the worst years of the US dollar bear.  Back then oil was a dollar thing!


Euro oilís current uptrend began from these humble basing roots.  By oilís second major USD high in October 2004, euro oil was only running at 0.56x the USD oilís gains.  In 2005, the USDX surged in a massive bear rally for the better part of an entire year.  During this rally euro oil shot up far faster than dollar oil.  By oilís third major high of this bull in August 2005, euro oil was up 0.63x as far as USD oilís 300% gain.


During much of 2005 and 2006, euro oil gradually climbed in a high consolidation.  Back then oil looked relatively stronger in dollar-neutral terms than it did for the US markets.  To the rest of the world, this is what high oil prices looked like until late 2007.  We are talking about Ä55 per barrel or so.  So oilís new highs today donít look quite as extreme outside of the dollar world as they do to Americans.


Dollar-neutral oil also fell farther in the sharp 2006 oil correction than USD oil.  But interestingly euro oil still largely remained within the wide uptrend it established in 2004 and 2005 while USD oil plunged way below its own uptrendís support.  And euro oilís big upleg since the resulting January 2007 lows remained within this uptrend until just the past couple weeks when it shot north of Ä70 per barrel.


Overall, oil in euros is up 276% in its bull to date versus dollar oilís massive 577% gains.  This works out to a ratio of 0.48x.  So from this perspective, it looks like about half of oilís total bull gains are fundamentally driven while the other half are dollar-bear driven.  The dollar bear deserves more credit than I originally suspected!


Incidentally the USDX is down 41% at worst in its bear to date while the euro is up 91% over this same time frame.  With the dollar nearly being cut in half and the euro nearly doubling, the 0.48x ratio between euro-oil and dollar-oil gains makes sense.  Nevertheless, a 276% dollar-neutral gain in the worldís most important commodity is nothing to sneeze at.  Fundamentals are definitely driving this global secular oil bull.


While the euro is likely to be the next world reserve currency, it is still just another hopelessly flawed fiat-paper currency.  Some would argue it is the worst kind of fiat too, as it is a composite currency of many countries that have long loved invading each other.  Can many sovereign nations with differing economic challenges and objectives hold the fragile euro together for decades to come?  Only time will tell.


To truly see fiat-currency-neutral oil prices, we have to look at oil priced in gold.  It is probably the best-available global representation of the rising real price of oil in its bull market.  To see the worldís most important commodity charted in terms of the worldís only currency with universal intrinsic value is striking.  Although I have watched the gold/oil ratio for many years now, this chart still stunned me this week.



In gold terms, oil is only up 107% in its bull to date!  And in a world teeming with fiat currencies backed by nothing but faith in politicians not screwing things up too badly, gold may be the only real standard of value left.  Gold oil is up just 0.19x USD oilís 577% gain.  While the real value of oil in terms of gold has still more than doubled, this is a far cry from the massive oil gains we have seen in US dollars.


Gold oilís uptrend reflects this with a far-more-modest upslope than fiat-currency oil.  At oilís cheapest in January 2002, it only took 0.063 ounces of gold to buy a barrel of oil.  This made gold oilís secular low much higher than dollar oilís as this dual zeroed-axis chart clearly shows.  Incidentally, gold was only trading at $285 per ounce back then while oil was just under $18.  How times have changed!