Commodities Dollar headwind for oil should give way to positive fundamentals

Expectations that US interest rates will stay higher for longer have also supported the USD dollar, which is a headwind for oil consuming nations whose currencies are not linked to the greenback, making the commodity more expensive in local currency terms.

Brent crude has fallen 2.3% so far this week, bringing its year-to-date losses to 5.6%. Another factor connecting oil and the USD are shifts in market sentiment. The dollar tends to benefit from risk-off environments and soften when risk aversion falls. Crude oil, on the other hand, tends to do well during periods of accelerating global growth and suffer during risk-off environments.

However, the negative correlation is far from stable over the last 30 years. While the dollar can impact prices, and it might remain a headwind for oil in the near term, we think the linkage is insufficient to make the greenback the key factor when guiding for the direction of oil prices. During periods of supply disruptions, oil can decouple from the USD and be driven by its fundamentals.

While we have lowered our forecast for Brent this year as a mild winter in the Northern Hemisphere has reduced demand for all fossil fuels amid more resilient Russian oil production, we still expect prices to move above USD 100 a barrel later this year. We see Brent at USD 100/bbl by June, and USD 105/bbl in the second half of 2023 with price supportive factors still in place.

A reopening China is supporting the recovery of oil demand. High frequency indicators for Chinese mobility show a continued rise in domestic flights and road congestion over recent weeks. In addition, we expect a pickup in international flights originating in China to support jet fuel demand in other countries, particularly in Asia. We look for Chinese demand to rise by 0.8 million barrels per day (mbpd) and global demand by 1.6mbpd this year. This should lead global oil demand to rise to record levels above 103mbpd in the second half of this year.

Declining Russian oil production is set to tighten the market. While recent data showed a pickup in Russian exports of refined products to Africa, the increase is unlikely to completely offset the drop in European imports following the ban earlier this month. In fact, data for the first 16 days of February indicated a drop in both seaborne crude and refined products by more than 550,000 barrels per day compared with January. Media reports also suggested that Russia plans to cut oil exports from its western ports by up to 25% in March versus February, exceeding the 500kbpd output cut announced earlier this month.

Supply growth from non-OPEC+ is only modest. We expect only modest supply growth in non-OPEC+ countries this year, due to underinvestment in the exploration and development of new oil supply, capital discipline, and high inflation. Last week, OPEC trimmed supply forecasts for Russia and other non-OPEC producers, while raising its global oil demand growth forecast.

With the oil futures curve downward sloping (in backwardation) and likely higher prices ahead, we continue to advise more risk tolerant investors to add long positions in longer-dated Brent oil contracts. Alternatively, investors can make use of lower spot prices and high option implied volatility by selling Brent’s downside price risk over the next six months. Another way to gain exposure for investors with a higher risk appetite is through Brent crude oil’s first-generation indices to benefit from solid roll returns on top of the expected spot appreciation. Our preference for oil also forms part of our most preferred rating on commodities in our global strategy.

Main contributors - Mark Haefele, Giovanni Staunovo, Daisy Tseng, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Dollar headwind for oil should give way to positive fundamentals, 23 February 2023.