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Dollar-Neutral Crude Oil

Adam Hamilton
Archives

April 25th, 2008

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 oil’s strength isn’t 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 doesn’t 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 didn’t 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 Street’s latest avoidance strategy is to blame the dollar, claiming oil’s 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 oil’s 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 oil’s strength to fade whenever the dollar rallies. This could really adversely affect their future gains.

If fundamentals are oil’s 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 oil’s 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 dollar’s role has been in oil’s bull. With the Fed actively trying to destroy the dollar’s 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 isn’t 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 doesn’t 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 dollar’s long reign as the world’s 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 index’s 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 world’s 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, oil’s 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 aren’t 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 oil’s 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 oil’s 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 shouldn’t jump to conclusions from one comparison. Instead it’s 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 €20.

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 oil’s 117%. Euro oil’s initial uptrend was more modest too, nowhere near as steep as dollar oil’s. And as euro oil’s 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 oil’s current uptrend began from these humble basing roots. By oil’s second major USD high in October 2004, euro oil was only running at 0.56x the USD oil’s 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 oil’s third major high of this bull in August 2005, euro oil was up 0.63x as far as USD oil’s 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 €55 per barrel or so. So oil’s new highs today don’t 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 uptrend’s support. And euro oil’s big upleg since the resulting January 2007 lows remained within this uptrend until just the past couple weeks when it shot north of €70 per barrel.

Overall, oil in euros is up 276% in its bull to date versus dollar oil’s massive 577% gains. This works out to a ratio of 0.48x. So from this perspective, it looks like about half of oil’s 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 world’s 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 world’s most important commodity charted in terms of the world’s 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 oil’s 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 oil’s uptrend reflects this with a far-more-modest upslope than fiat-currency oil. At oil’s cheapest in January 2002, it only took 0.063 ounces of gold to buy a barrel of oil. This made gold oil’s secular low much higher than dollar oil’s 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!

Like euro oil, gold oil was largely flat from 2002 to mid-2004. It ground sideways for the most part as its 200dma reveals. Nevertheless, some rare extremes helped define a support line that has held to this very day and an initial resistance line that gold oil just happened to hit again this week. Later oil spikes would start to define a second higher resistance line, but the original remains the one repelling gold oil the most.

Interestingly, until mid-2005 gold oil tracked euro oil pretty well. At dollar oil’s first three major bull highs, gold oil’s ratio to dollar oil’s gains ran 0.63x, 0.49x, and 0.52x. This isn’t all that different from euro oil’s parallel ratios of 0.65x, 0.56x, and 0.63x. Prior to mid-2005, gold was in a Stage One bull driven by the dollar bear, so this makes sense. Since mid-2005, gold has decoupled from the dollar and is now driven by global investment demand in Stage Two. So gold’s gains have far-outpaced the dollar’s losses since.

Oil priced in gold reached its peak in late August 2005, at 0.162 ounces per barrel. Provocatively this is far higher than gold oil today! So relative to gold, oil has been getting less valuable since then. This sure paints a different picture of this oil bull than viewing it in fiat currencies does! That 2005 price spike was an anomaly, as it was driven by hurricane Katrina ripping through US oilfields. Nevertheless, today gold oil is still not extreme relative to recent history.

Oil priced in gold, of course, is the inverse of the classic gold/oil ratio. While long-term GOR analysis is very interesting, there is a major criticism against it. Why should the ratio between gold, almost all of which that has ever been mined in world history still exists, and oil, which is burned immediately upon production and forever lost, remain in a constant range? This is a great question that plagues multi-decade GOR studies.

But over the short term, this question is a lot less relevant. There isn’t much more gold around now, in terms of world supply percentage growth, than there was 5 years ago. So the gold oil price trend is far more likely to be relevant over years than decades. Since gold oil has largely remained in its current uptrend for over 6 years now, odds are this trend remains in force today.

Obviously this has big implications for traders. Today gold oil is at its lower-resistance line, the point at which oil has usually retreated in gold terms. The only way gold oil can retreat today is if dollar oil falls, dollar gold rises, or some combination of these two transpires. Since oil is widely loved by speculators and overbought today while gold is increasingly despised and oversold, I suspect it will indeed be a combination.

In secular bulls, a price’s 200-day moving average is its highest probability support zone to bounce at in a correction. So if oil corrects, its 200dma which is now at $90 (€62) is a logical downside target. If gold oil falls to its bull support, which has yet to be materially violated, we’d be looking at 0.09 ounces of gold to buy a barrel of crude oil. At $90 oil this yields a gold target of $1000 per ounce, higher than today’s levels.

Of course there are many other oil-price and gold-price scenarios that would keep gold oil traveling within its well-established bull uptrend. But most involve high or rising gold prices relative to recent history. While I can’t prove it, over the years I’ve seen plenty of anecdotal reports indicating major oil producers watch oil pricing in gold. It gives them a solid metric for their depleting resources independent of other countries’ fiat-currency manipulations.

Back to the task at hand, the modest uptrend of gold oil has many implications. Oil in gold terms has still more than doubled so a secular fundamentally-driven currency-neutral oil bull absolutely exists. Yet a 107% real bull run over 6+ years is pretty modest. We are talking about a compound annual gain of just 12.3% here. This makes oil’s bull look much more reasonable and much more sustainable than its dollar rendering implies.

This heretical view challenges a lot of widespread assumptions. Wall Street loves to throw around the word “parabolic” when it describes oil, yet oil hasn’t even come close yet even in dollar terms. Going parabolic is many consecutive days of 4%+ daily gains, rare climax-stage events. And when viewed in gold, oil’s secular upslope remains so modest that technically it looks like we are at least a decade away from true parabolic oil gains.

Politicians love to demagogue on high oil prices while consumers love to whine about them. But in real terms, oil is a lot cheaper today than it was in the summer of 2005! It is too bad the US Congress and American people will never understand this. We are all trapped in viewing the world through the lenses of our own fiat currencies, but as our central banks debase them it radically distorts our perceptions of real price trends.

So dollar-neutral oil is pretty interesting. In some ways it is great as it proves this oil bull is a global supply-and-demand driven beast totally independent of currencies. It shatters Wall Street’s oft-advanced thesis of late that oil is only rising because the US dollar is weak. Nonsense! On the other hand though, the perpetually-inflating fiat currencies are having a bigger impact on oil’s nominal prices than I expected.

When viewed in euro terms, it looks like about one-half of oil’s dollar bull is fundamental. But when viewed in gold terms, this fraction drops to merely one-fifth. This is somewhat disturbing as it calls into question all kinds of perceptions about nominal price moves in all assets worldwide. Perhaps everyone, even students of monetary theory, is seriously underestimating the impact of fiat inflation on asset prices.

Even if our currency measuring sticks are this hopelessly flawed, there is no doubt commodities and commodities stocks have been rising much faster than any other major asset class in recent years. This makes them the premier destinations for investment and speculation capital. At Zeal, we have been investing and speculating in commodities stocks since these bulls began in the early 2000s.

And due to the persistent global structural deficits in producing many commodities, these secular trends are likely to continue. World production can’t even hope to keep pace with surging emerging-market demand as Asia industrializes. If you want cutting-edge analysis on key commodities and their producers, subscribe today to our acclaimed monthly newsletter. We are constantly analyzing the world scene to look for high-potential-for-success trades in elite commodities stocks for our subscribers.

The bottom line is this oil bull that Americans are marveling over looks a lot less impressive in dollar-neutral terms. Rendered in euros, it looks like the dollar bear could be responsible for half of oil’s total gains. But rendered in gold, this number could jump to four-fifths! Either way, the dollar bear is still not the whole story as Wall Street suggests. Global oil supplies are simply growing too slow relative to worldwide demand.

And considered in alternate currencies, oil does not look anywhere near as overbought as it does on dollar charts. This increases the odds that we’ll see continuing high consolidations in oil in dollar terms, not the sharp plunge many mainstream traders are hoping for and betting on.

Adam Hamilton, CPA

April 25, 2008

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