“We watch the value of the U.S. dollar, along with the performance of emerging markets reflected in various stock market indices”

While we usually focus on fundamental supply and demand trends as we attempt to gauge how the oil and gas business is performing, it is sometimes interesting to revisit a few of the more technical indicators. While we call them technical, suggesting they are primarily financial indicators, they are actually reflections of the fundamentals of oil and gas supply and demand.

The two measures we follow closely to understand oil price and energy stock trends, are not used for trading purposes, but rather indications of the state of broad forces at work in the global economy and commodity markets. In that regard, we watch the value of the U.S. dollar, along with the performance of emerging markets reflected in various stock market indices. Because oil is priced in U.S. dollars, the value of the dollar determines how much a barrel of oil costs foreigners. When the dollar’s value falls, it reduces the cost of a barrel for foreigners, encouraging them to use more. Conversely, when the dollar’s value rises, oil prices become more expensive, discouraging its use.

The performance of emerging markets is another important indicator, as it reflects the health of foreign economies. When those economies are doing better, their growth means increased purchases of commodities that are essential to support the growth, and vice versa when economies are weak.

As we assess what these measures are telling us about the future for oil prices, it is helpful to look at where we are. Oil prices in 2019 rose steadily during the first quarter of 2019, before slumping and then essentially remaining flat throughout most of the second half of the year. Prices did rise during the fourth quarter, as they came up from a 2019 low price set early in the quarter. As oil prices crossed $60 a barrel at the end of 2019 and beginning of 2020, optimism grew that better days were ahead for the industry.

That optimism was soon eroded as people began to doubt the resolve of OPEC and its partners, primarily Russia, to cut more oil output to counter the growing rise in crude oil inventories during the seasonally weak first quarter. Forecasters were warning about the continuing imbalance between supply and demand, arguing that rising inventories would depress future oil prices. Also beginning to haunt the oil market was news from China about the growing spread of the coronavirus. Initially, this was not taken as seriously as it should have been, given the celebration of the Chinese New Year that distorted demand data. However, when the Chinese government began locking down Wuhan where the virus originated, and the virus spread to Italy, alarm bells started ringing about the potential for a global pandemic with serious oil demand erosion implications.

Concerns over demand destruction grew, as various governments in Europe, Asia and North America began implementing travel bans and economic lockdowns. Predictions for demand losses escalated. At the same time, oil prices were slammed by the announcement that the OPEC+ output cut agreement would not be extended. As a corollary to the dispute between Russia and Saudi Arabia, the two oil giants announced plans to step up their respective outputs and to target the export markets of each other by cutting prices for customers. The oil price rout was on.

“Oil prices were slammed by the announcement that the OPEC+ output cut agreement would not be extended”

How Oil Prices Tracked Last Year and Now

When Saudi Arabia began pumping millions of barrels of additional supply into tankers destined for Asia, Europe and the United States, industry concern quickly shifted to whether the world had sufficient crude oil storage capacity. With demand collapsing, refineries were rapidly trying to adjust their operations, but also seeking storage capacity for unneeded refined product. Storage shortage panic set in, driving oil prices sharply lower.

The storage panic peaked as we approached the expiration of the April oil futures contract. Many inexperienced investors suddenly found out that if they owned the futures contract at its expiration, they needed to able to take physical delivery of the thousand barrels of crude oil represented by the contract. Where to put this oil, especially for people with no experience or connections within the real oil business, set off a new panic, which eventually drove the oil price to a negative $37 per barrel price. This was a first for the industry. Futures contract owners were actually paying others to take their oil! In reality, these naive investors were being taken to the cleaners by pros who held unused storage capacity and were able to lock in significant profits by accepting negative oil prices and then selling the oil forward at significant positive profit margins.

As the oil price rebounded but the fundamental news remained dismal, we focused on how the 2020 oil price performed compared to the 2014-2016 and 2018-2020 price history. The two prior downturns had mirrored each other for much of their duration. The initial 2020 price action was also following the earlier downturns until we entered the storage panic period. Absent the huge negative price spike, the recent rebound has produced a price curve mirroring the early months of the prior downturns. If we are mirroring prior downturns, what can we learn from looking at how the value of the U.S. dollar and the performance of emerging markets impacted oil prices?

“These naive investors were being taken to the cleaners by pros who held unused storage capacity”

Tracking Oil Prices In Recent Downturns

Utilizing an older chart covering 1973 to 2017 (Exhibit 3, prior page), we see how oil prices reacted to declines in the value of the U.S. dollar. The chart highlights three declines in the dollar’s value associated with oil price increases. The first was during 1975-1980, which coincided with the tripling of oil prices usually attributed to the Iranian Revolution and the loss of a significant volume of global oil supply. All the petrodollars generated by the substantially higher oil price helped boost the value of the dollar to a peak in 1983. The surge in new oil supply and the cheating among OPEC members kept oil prices under pressure, until Saudi Arabia abandoned support for the OPEC marker price and decided to teach its fellow OPEC members a lesson by boosting its production and driving oil prices down. That meant fewer petrodollars being available, causing the dollar’s value to collapse. When the dollar’s value bottomed in 1995, the long, steady rise in oil prices came to an end.

“The two prior downturns had mirrored each other for much of their duration”

Major Oil Price and Dollar Value Corollary

A similar dollar value decline occurred from 2000 to 2011, and was associated with soaring oil prices. Fundamentally, this period encompassed a jump in global oil demand driven by China’s insatiable consumption, and the rapid rebound following the Financial Crisis. The post-crisis demand story was helped by fears of a peak in global oil supply. High oil prices drove the shale revolution and the boom in offshore drilling, bringing into production significant new supplies of oil.

Oil Prices And Possible Drivers

We complicate the analysis in the very busy chart in Exhibit 4. Here we are tracking both the dollar’s value and the performance of emerging markets, along with oil prices. We have shown the broad trends for each data series with arrows. Again, while we are only covering 2006 to 2020, the relationships between rising and falling oil prices is tied closely to movements in the value of the dollar and emerging markets performance.

Given this correlation, it is interesting to note where we are currently. As the chart shows, we are either just ending a period of U.S. dollar strengthening, or it is a brief downward move in a long-term uptrend. Does the recent recovery in oil prices to above $40 a barrel suggest a change in trend, or is it a kneejerk reaction to the storage panic that drove oil prices to absurdly low levels? There is little doubt that optimism about the pace of the economic reopening, supported by upticks in daily and weekly activity measures, has helped lift the oil price. The recent pauses in state re-openings due to outbreaks of Covid-19 will depress demand, and thus oil prices. It is important to understand that daily fluctuations in these measures should not be relied upon as triggering reversals of trends, and thereby trading signals.

To that point, we were intrigued to hear a theory expounded on CNBC that when the dollar value index goes above 100, it is a trigger for a change in direction that lasts for upwards of three years. We haven’t done an extensive examination of this theory, but we did look at it during the past three-plus years. The dollar value index recently spiked above 100, which was the first time since early 2017. From the last time the dollar value index was above 100, we find oil prices now are at about the same level as then. However, during the interval, oil prices spent most of the time above where it was in early 2017. The same pattern appears to be true for emerging markets. The better relative performance was much greater in the earlier portion of the period than in the latter part. That may reflect other events impacting oil prices.

“As we move through the second half of 2020, concern will grow over the lack of oilfield spending and activity, which would seem to dictate a sharply higher oil price in 2021”

Have Higher Oil Prices Been Set In Motion?

As we look at these technical measures, as a guide for the future, we need to consider the fundamentals for crude oil. Although the long-term oil demand outlook is cloudy, near-term demand is destined to experience a rapid recovery. The news about the economy will be bumpy, but since we are coming off such a significant low point, it is almost axiomatic that we will experience a strong rebound. As we move through the second half of 2020, concern will grow over the lack of oilfield spending and activity, which would seem to dictate a sharply higher oil price in 2021. Whether we get to $100 a barrel, or J.P. Morgan’s $190, price is less important for the outlook for the industry, as the significantly reduced cost structure of E&P companies will provide them ample money to drill and exercise financial discipline – paying down debt and returning capital to shareholders. The bankruptcy landscape will offer exploration upgrades for those producers who are financially strong. That will translate into more activity, but also better-quality wells. That will become the 2022 story, and will act as a cap on how high oil prices rise. Importantly, investors won’t need $100 a barrel oil to justify backing companies, given the depressed share prices. While the November 3 election remains a wildcard, we are months away from people voting. We have learned from the past four years that events can surprise more than anyone can imagine.

Just as the petroleum industry that exited the 1990s was very different from the one that entered the decade, we are about to witness a similar restructuring. It will set the stage for improved industry fundamentals that will create value, even though the fears over the long-term outlook for the industry will overhang. Remember, stocks rise on walls of worry, and for energy there is plenty to worry about!

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