Oil’s inverse correlation to the dollar could return

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The price of black gold often falls when the US dollar strengthens.

However, the traditional inverse correlation between crude oil and the US dollar – when one goes up, the other comes down – has broken down over the past two years. 

The trade-weighted US Dollar Index (DXY) was 96 in February 2022 on the eve of two epic world events: the Russian invasion of Ukraine and the onset of the Federal Reserve’s most draconian monetary tightening programme since the Volcker Fed in the early 1980s.

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Then, the rise in the Fed Funds rate and the geopolitical shock of the bloodiest war in Europe since Yugoslavia in the early 1990s led to a surge in the greenback against its major G10 peers.

The US Dollar Index rushed from 96 to its cycle high of 114.8 in September 2022.

In the oil markets, the Ukraine war and Western sanctions on Russian oil exports led to an initial panic that saw Brent rise from $94 to as high as $123 in June 2022 as a geopolitical risk premium boosted crude oil.

The rise in both oil and USD is not supposed to happen. King Dollar reasserted its inverse correlation linkage with Brent crude once the energy markets absorbed the supply shock angst of the Russia sanctions.

As I write, the US Dollar Index has plummeted to 103.7 as US Treasury bond yields slumped in November 2023.

The dollar has been dethroned by Wall Street’s conviction that the Powell Fed’s tight money cycle is done and that US interest rates have peaked as global economic momentum decelerates in 2024. 

Reuters/Kevin Lamarque

Yet, back in the oil markets, Brent crude has also fallen sharply from its post-October 7 high of 95 to 75 now.

Statistically, it is premature to conclude that a positive correlation will now define the linkage between the US dollar and crude oil, though the greenback is now a de facto petrocurrency.

Yes, the US is the world’s largest oil producer with 13.25 million barrels per day (bpd) in output, and American LNG and liquid fuel cargoes are now a major factor in European energy pricing.

Saudi Arabia’s voluntary 1 million bpd output cut at the June 2023 Opec+ conclave in Vienna led to a frenzied but ultimately doomed bullish run in Brent from $74 to $95.

This spike in Brent coincided with a period of US dollar strength as the bond market was then convinced that inflation data was above the Powell Fed’s 2 percent dual mandate target and precluded the end of the tight money.

So Brent crude and the US dollar were again temporarily rising in unison, in violation of that traditional inverse relationship.

Nevertheless, in the past month there has been a dramatic sentiment U-turn in the oil futures markets where trading volumes often dwarf the 101 million bpd of tanker cargoes consumed in the physical markets by a multiple of 15 to 20 times.

Here the bears dominate. Even though Saudi Arabia’s output has fallen 3 million bpd below capacity level and Opec+ has just announced another 900,000 barrels a day in output cuts, oil traders are convinced that the supply surge from the US, Venezuela, Brazil and Mexico, coupled with quota non-compliance by Iran, Angola, Iraq, Libya, Nigeria, Kazakhstan and Algeria, will exacerbate the glut in diesel, gasoline and distillate product prices.

Moreover, the Biden White House has ignored Iran’s output surge to 3.2 million bpd, a sharp rise from its 1 million bpd output during Trump’s “maximum pressure” sanctions in 2018.

Nor does the demand outlook look promising. China and Europe both face the big chill of industrial recession, while US consumer spending metrics show a sharp rise in credit card delinquencies and a fall in used car prices. 

How long will Saudi restraint continue, since its role as a “swing producer” of Opec is costing the kingdom tens of billions in lost petrodollar revenues every month?

If Saudi Arabia unilaterally raises oil production by, say, 2 million bpd, all bets are off.

Brent could fall below $60 and its traditional inverse correlation with the US dollar could return to haunt the global markets with a vengeance in 2024.

Matein Khalid is the chief investment officer in the private office of Abdulla Saeed Al Naboodah and the CEO designate of a venture capital firm. He is also an adjunct professor of real estate investing and banking at the American University of Sharjah.