One of the more interesting developments over the past nine months is the rising price of Oil within a rising U.S. Dollar environment. Since early May 2016, we’ve seen both Oil and the Dollar increase in value. While not impossible, it’s a relationship dynamic worth paying attention to. More often than not, a falling Dollar is a tailwind for commodity prices. Conversely, a rising Dollar is a headwind for commodities, like Oil. For example, from July 2014 through March 2015, the U.S. Dollar appreciated almost 26% against other major currencies (using the U.S. Dollar Index as our gauge). During the same timeframe, West Texas Crude (continuous contract) dropped almost 58%. So when we see black gold and the mighty greenback rising together, we sit up and take notice. Oil is showing some strength in the face of a mighty headwind.
Check out the charts below. First, we see the normally negative correlation between the U.S. Dollar and Oil in full effect. The chart is a bit color-crazy at first. Take time to digest it. The upper pane is the U.S. Dollar. The lower pane is Oil. The majority of the time, when the Dollar falls, Oil rises and vice versa. However, sometimes they move together, or one is moving a direction while the other is flat. This latter characteristic can be a precursor of major price moves to come. Look at the period in late-2010 through mid-2011. The Dollar is rising and Oil is flat. What happens when the Dollar finally falls in value? Oil jumps 68%. Similarly, as foreshadowed in the opening of this article, the period of mid-2013 through mid-2014 had the Dollar down, yet Oil could not budge upward. As soon as the Dollar took off in mid-2014, Oil’s 2013 weakness during a falling Dollar period was a precursor to a nasty 58% drop in value.
Further examination of the chart above shows we’re currently in a period where the Dollar and Oil are rising together. This synchronized move has been in place since early 2016. This is a warning. Eventually, one or the other will give and the subsequent price moves will be fast and furious. If the Dollar keeps rallying, expect this recent Oil breakout to fail. On the other hand, if the Dollar drops here, we could see an impressive upward move in Oil which targets $75 (+41% from current levels).
Digging deeper into our analysis, we find seasonality can be an important part of our process. Seasonality, in relation to markets, is simply the recurrence of similar price movements during certain periods of the year. It’s the tendency for commodities (or stocks, bonds, currencies) to perform better during some time periods and worse during others. Seasonality is not as important as price itself, but it’s still a powerful piece of evidence. What does seasonality look like for the Dollar and Oil? I thought you’d never ask.
Below is the seasonality of Oil for the past 10 years. This shows the percentage of months in which Oil closed higher than it opened. The bar height shows the percentage time that a month is positive. The number at the bottom of each bar is the average return for that month during the past 10 years. Accordingly, January’s bar represents the past 10 Januarys. We can easily see Oil has been up in January only twice (20%) in the past 10 years with an average return of -3.5%. When we look at this year, however, it sticks out like a sore thumb. As of Friday’s close, Oil is up about 1.7%. This could obviously change between now and January 31st. But the strength out of Oil during a seasonally weak month for this energy commodity is worth noting. In addition, February is almost a week away. During the past 10 years, February has been the best performing month for Oil by a wide margin. Up 90% of the time with an average return of +5.1% is significant. Combined with the correlation (or lack thereof) highlighted at the beginning of this article and the breakout levels identified below, there is a powerful case to be made that Oil is on the verge of a large move upward move.
Not to be ignored, here’s the seasonality chart for the Dollar. It uses the same parameters as the seasonal chart for Oil. Right off the bat, we notice January is an okay month for the Dollar; up 55% of the time with an average return of 0.8%. For the current month, however, the Dollar is down almost 2.5%. And next month’s seasonality for the Dollar is quite different. The Dollar is only up 40% of the time with an average return of -0.1%.
So we are heading into February, which is one of the weakest months for the Dollar and the strongest month for Oil during the past 10 years. We think things are about to get very interesting for one of the most important commodities on the planet.
Let’s dig into some charts of Oil and the Dollar. We know that each asset must stand on its own merit from a price perspective. And we care about important levels of supply and demand as they mark levels of risk when we consider entering a trade. In addition, if we’re going to enter a trade, we better have an exit plan. Identifying areas of supply and demand can help us do just that. Scrutinizing both charts brings further clarity about important risk management levels. After all, if we’re trying to make money in the markets, we’re in the risk management business. We care about being on the right side of the trade. And if we’re on the wrong side, it would make sense to know WHEN we’re on the wrong side.
Here’s the weekly chart of Oil.
The weekly divergence between price and 14-period RSI was a clue that Oil would eventually rebound. Since early 2016, we’ve seen Oil rally (don’t worry, it started before Trump was President so we can’t call this a “Trump Rally”). This past December, Oil broke through and held the $50 level. Previously an area where sellers showed up to drive price back down, a move above this level was significant. And the longer it holds above this level, the more significant that breakout is.
Here is the daily chart of Oil.
It’s easy to see Oil price consolidating and compressing above the very important $50 level. A break upward out of this consolidation would start the race to $75. On the other hand, we want nothing to do with this underneath $50. The line in the price is clear. Above $50, it makes sense to own it. Below that, it can be someone else’s problem.
Likely to be in conjunction with Oil’s next leg, is a move in the US Dollar. Nothing is guaranteed. Oil and the Dollar can keep moving in similar directions. But, the evidence suggests that when the current positive correlation is broken, both will experience significant moves.
Here’s the weekly chart of the US Dollar.
Just like Oil, the US Dollar broke out above previous resistance in the 4th quarter of 2016. Specifically, this important piece of paper broke above $100 this past November. This level had sellers show up a few times in 2015. The ability of buyers to drive this major currency above $100 is significant. On the flip side, if the Dollar cannot hold $100, it could signal a false move. And from false moves, come fast moves in the opposite direction.
Here’s the daily chart of the Dollar.
On the daily chart of the US Dollar, we’re testing that all-important $100 level. If price moves below this level, there is no reason to own this major. Above $100, own it. Below $100, don’t own it. It’s that simple. And if the Dollar moves down through this important level, we could have a false move on our hands, with selling pressure picking up and providing a major tailwind to the other important asset in this article, Oil.
We’ve covered a lot of ground and looked at some important charts. The thesis is simple. The next big move in Oil is likely to be dictated by the Dollar’s next move. If the Dollar breaks below $100, and Oil breaks upward out of consolidation, the thesis of Oil going to $75 becomes that much stronger. The opposite also applies. If the Dollar holds $100 and Oil drops back below $50, we want to own Dollars and have nothing to do with Oil.
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Here’s to being on the right side of the trade.
Disclaimer: Nothing in this article should be construed as investment advice or a solicitation to buy or sell a security. You invest based on your own decisions.