To The Moon

Crude oil ($W&T Offshore(WTI)$) has had a strong largely-bullish run over the past year or so. As the world emerged from the pandemic-induced slump in movement slump created massive pent-up demand, OPEC+ nations maintained increase in production along plans made years in advance and largely refused to budge in terms of quotas. Unsurprisingly, this led to a spike in crude oil prices for over a year, i.e. well before the Russian “special military operation” in Ukraine.

However, since the start of this month till last week, the effective drop in the US Oil ETF (NYSE ticker: USO) – which invests primarily in futures contracts for light, sweet crude oil, other types of crude oil, diesel-heating oil, gasoline, natural gas, and other petroleum-based fuels – was a little under 3%:

A net drop of 5.45% was observed till the 22nd

Over the past week alone, the drop was a staggering 8.4% – which was followed by a further 3% drop as of the 22nd.

Now, This is being tied to the U.S. Federal Reserve’s decision to enact what is commonly referred to as a “Fed rate hike”. The “Fed rate” refers to the Federal funds target rate. A group within the U.S. Federal Reserve System – the Federal Open Market Committee (or FOMC) – sets a target range for the federal funds rate, which provides a reference for the interest rates large banks charge each other for “overnight loans”. When this rate is hiked, this provides an impetus for all economic participants to spend less and save more, thus reducing the total money supply and easing inflation. The higher cost of business for companies in the face of fewer business transactions signals lower revenues and earnings, which is reflected by an impacted business growth rate and stock valuations.

Over the decades, this has had an impact on oil prices as well. Oil prices rise when the supply-demand gap is tilted towards higher demand. With less business, less demand is implied. Thus, oil prices will take a dip. This is clearly evident in patterns in abrupt shift in crude oil trajectories over the past sevral years in the pre-pandemic era.

A rate hike typically triggers an oil price drop for some time

However, it bears noting that “dovish” moves by the Fed – meaning small changes in the rate – do little to address extensive inflationary momentum. In the past, crude oil prices follow a downward trend to a point before galloping away again (and with it inflation rates).

Historically, U.S. CPI and Oil prices tend to chase each other

Over the past two years, the rate of inflation change has steadily gone well past levels seen during the 2008 Financial Crisis. It bears noting that the Consumer Price Index (CPI) measures a “basket” comprised of percentages of various items such as food, energy, electricity, etc. to provide an indicator for directionality of price increases. In other words, it isn’t an “average” increase of household expenses; actual increases in wheat, bread, meat, lumber and fuel (of any kind) are far in excess of the CPI rate.

Given the supply-demand gap that remains unchanged by OPEC+ and exploration & production restrictions in the U.S., crude oil prices remained relentlessly bullish – thus impacting household savings. With no effective inflation-adjusted wage increases to stave this off, there is now a downward pressure being implied on consumption.

With investors piling into energy stocks over the past year, the sector now registers as “oversold” in the current month, thus leading to a recent collapse in energy stock prices.

Source: Bespoke Investment Group

In terms of 50-Day Moving Averages (50-DMA) – a simple and effective tool used by traders to analyze the technical health of stocks, with those being above this line being considered “healthy” and those below it “not healthy” – the number of energy companies’ stocks above their respective 50-DMA has gone from 100% to zero in the past week alone.

Furthermore, it was announced on the 21st of June that the U.S. Treasury – in consultation with some U.S. allies – is working on a“Russian oil price cap” to limit the funds inflow the Russian government is gaining from high crude oil prices. One means being explored effectively increases ease of access to Russian crude oil. As it turns out, a big factor of the rise in oil price after the Russian invasion of Ukraine began were EU/UK countries' sanctions which banned insurance to energy transits through Europe. This was possible because EU/UK companies have a near-monopoly in shipping insurance. The "Russian oil price cap" proposal seeks to end this ban on insurance, which will reduce oil prices and, thus, Russian revenues. However, EU officials immeidately announced that that this is "very difficult" to do. 

There's another interesting consequence of the sanctions: "oil contracts" are, largely by default, denominated in U.S. dollars. When the contract is paid, a significant portion of that amount ends up in oil-exporting countries' central banks as "petrodollars", keeping them outside of the U.S. money supply. For quite some time now, China and India - the world's 2nd- and 3rd-largest energy consumers - have been pushing for contracts priced in their currencies. This is because a rising dollar and rising crude prices act as a "double whammy" to their balance of trade. The latter may be unavoidable sometimes but their reasoning is that the former can be arranged, at the very least.

Since the sanctions began, India has been purchasing large amounts of deeply discounted oil from Russia. With the discount, the transit risk and increased transit costs could be managed. Just before April, Russian oil imports - because of the transit costs - accounted for just a little over 1% of total imports. In May, Russian oil accounts for almost 18%. Furthermore, it was reported on the 20th of this month that Russian and Indian banks are close to an agreement wherein rupee/rouble transactions would be enacted without using the U.S. dollar as an "intermediate step". China has also increased imports from Russia and, interestingly, is working on an agreement to pay for Saudi oil using Chinese yuan. Many officials in Saudi Arabia are reportedly in favour of this since the earned yuan can be used to pay Chinese companies operating in the country while diversifying their bank deposits. 

This has several consequences over the long term. If other currencies such as the rupee and yuan become acceptable in oil contracts (which looks increasingly likely), the "petrodollars" will find their way back to U.S. shores, thus creating an increase in money supply, which will exacerbate inflationary pressures. 

Lowering oil prices is good news for people's wallets and an opportunity for the disciplined tactical investor. As upward and downward pressures battle, expect some churn. Even if they don't typically invest in commodities, exchange-traded products exist that can be utilized to cash in: for example, $LS 2X LONG WTI OIL ETP(WTI2.UK)$ can be used to bet on the upside with a 2X daily-rebalanced leverage while $LS -2X SHORT WTI OIL ETP(WTIS.UK)$ will create the same exposure on the downside of oil movements. 

NOTE: This article is adapted from a highly-detailed article on my Substack - https://sandeeprao.substack.com - where I focus more on global business, markets, Asia (+ India), culture, trends and how they tie in together. I cover nuances that no single media source generally provides. The articles are not published weekly; instead, I dig deep into a topic whenever it becomes interesting to do so.

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