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[color=red][/color]Why oil prices will head back toward $20 next winter

By Ivan Martchev

Published: May 26, 2016 3:46 a.m. ET


Demand is more important than the dollar for oil

One of today's more fascinating examples of a widespread misunderstandings of cause and effect is that of the relationship between the U.S. dollar and crude oil or, if you prefer, the larger definition of the same problem — the dollar vs. commodity prices.

Commodity prices are down over the last two years, but not because the dollar is strong. They are down because there is too much supply and not enough demand. That causes commodity-related currencies — such as the Brazilian real, Russian ruble, South African rand, and the Canadian and Australian dollars — to be weak against the U.S. dollar (from a long-term perspective, not a couple of months).

Then, there is the issue of the tapering of QE and the threat of more rate hikes in the U.S. (which should be cancelled, in my opinion), plus the acceleration of QE in the eurozone and Japan, and the global experimentation with negative interest rates.

The exchange rate of the U.S. dollar is a multi-variable equation and certainly not just a function of Fed policy, although that remains one of its rather important drivers. That said, there is a certain degree of reflexivity when the seasonal rally in oil is being mistaken for a major bottom.

“I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts. As another example, declaring that government is bad tends to make for bad government."
—George Soros’ “General Theory of Reflexivity”

Oil demand tends to be stronger in the March-to-September period and much weaker during the fall and winter months. That's because more people live in the Northern hemisphere, so there is more oil consumed for transportation purposes during the warmer months. This seasonal rebound is also helping multiple commodity currency pairs, previously under pressure, to rebound and cause a decline in the Broad Trade-Weighted Dollar Index (see chart here).

With oil inventories high, and with global and U.S. production also at high levels, I think we are headed back toward $20 per barrel oil prices come next fall or winter. Since the seasonal rally in oil started in February — earlier than usual — the price may also top out earlier than it did last year.

I do not expect significant upside past the present level of crude oil prices, barring unforeseen escalation in military activity in the Middle East, which presently is experiencing a lull in disturbing headlines — which is not the same as a lull in actual hostilities. I think that the Broad Trade-Weighted Dollar Index will surpass the high we saw in January of this year when the oil price takes out its January low, which should happen in the next six to 12 months.

What commodities mean for a potential rate hike

This seasonal rebound in commodity prices has also helped many developed-market currencies like the euro. This commodity-price rebound is alleviating concerns about entrenched deflation in the eurozone, but I think this amounts to a false hope. I fully expect the euro to resume its decline and ultimately reach parity to the dollar (1:1), which may not be the end of its long-term decline.

The eurozone inflation rate is now -0.2%, while German inflation is 0.1% and German 10-year bunds yield a hefty 0.14%. European Financial Stability Facility 10-year bonds, which are currently being taken for eurozone-area "confederate" bonds, now yield -0.3%. It appears that the ECB QE maneuvers are "too little too late" and are not producing results on the eurozone deflationary front. This means that the ECB will likely accelerate QE, or eurozone deflation will get worse.

In either case, that means the EURUSD cross rate is likely headed lower. It is possible that both will happen — the ECB accelerates QE and the deflation picture gets worse — at which point the end result for the euro exchange rate is still a decline.

In this global deflationary environment, it has been fascinating to see plans for more Fed fund rate hikes, which I view as nothing but absurd. I don't think that the U.S. economy is that weak that it cannot handle somewhat higher interest rates, but I think the global economy is much weaker than the Fed appreciates.

I think the Fed could have gotten away with some more rate hikes if they had started a year or so earlier, but at this point, things have gotten so out of hand in Europe, Japan, and now China, that the present Fed rate-hiking cycle now looks ludicrous.

December fed fund futures (ZQZ16) rallied as high as 99.525 in reaction to the employment report, which market participants originally viewed as reason enough for rate hike cancellations. At present, Fed fund futures are again selling off on the renewed jawboning by the Fed over the past week for a June rate hike. I don't doubt the ability of the Federal Reserve to hike one more time in 2016, but that would be a mistake.

Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates . The opinions expressed are his own. Navellier and Associates holds no positions in any investments mentioned in this article. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

http://www.marketwatch.com/story/demand-is-more-important-than-the-dollar-when-it-comes-to-oil-2016-05-25?mod=MW_story_recommended_tab