Strong dollar inflicts more pain on oil as bearish options bets build

By: | Published: January 12, 2016 3:55 PM

A stronger U.S. dollar is compounding an oil market rout that has seen crude prices fall by almost 20 percent this month, and options trades suggest the market is preparing for deeper losses ahead.

A stronger U.S. dollar is compounding an oil market rout that has seen crude prices fall by almost 20 percent this month, and options trades suggest the market is preparing for deeper losses ahead.

The accelerated oil price drop since the beginning of the year has been largely blamed on China’s stock market turmoil and its slowing economy, yet the dollar’s strength is emerging as another important bearish factor, traders and analysts said.

The U.S. dollar index has risen more than 20 percent since mid-2014 as a relatively robust U.S. economy attracted investor flows from other regions. The Federal Reserve’s first increase in U.S. interest rates in a decade in December and the prospect for further rises are expected to continue underpinning the greenback going forward.

Since oil is traded in dollars, a stronger greenback makes it more expensive for countries using other currencies to buy fuel, potentially denting demand.

“No doubt, U.S. dollar is a key factor that is driving the oil price down,” said Oystein Berentsen, managing director of crude oil at trading company Strong Petroleum in Singapore, although he said there were many reasons for the price collapse, “the basic one being overproduction.”

Crude oil futures have fallen more than 70 percent since mid-2014 as soaring global production leaves hundreds of thousands of barrels every day without buyers, creating an overhang that storage facilities around the world are struggling to cope with.

Compounding this, analysts say that the robust dollar has been playing an increasing role in crude price falls since last November.

“There is an FX problem, and it may get worse,” Morgan Stanley said in a note to clients this week.

“When we assess the over 30 percent decline in oil since early November, much of it is attributable to the appreciation in the trade-weighted USD,” Morgan Stanley said.

CLOSE DOLLAR/OIL PRICE LINK

Market data suggests that the dollar and U.S. crude are indeed closely linked.

Since the start of 2015 the rolling one-year correlation between U.S. crude and the dollar weighted against a basket of currencies has had an average negative correlation of around 94 percent as the greenback strengthened and oil fell.

Morgan Stanley said this trend could intensify if Chinese policymakers continue to steer the yuan lower in a bid to spur economic activity. “If rapid devaluation occurs, a 15 percent CNY (Chinese yuan) depreciation alone could send oil into the $20s.”

U.S. crude West Texas Intermediate (WTI) and Brent crude futures are now hovering close to the $30 a barrel mark and a recent surge in bearish options market activity points to further falls.

Put positions tied to a $20 strike price in December Brent crude oil futures have risen more than 700 percent since the start of the year, and WTI put open interest is up more than a third at the March $20 strike.

Put option positions and prices tied to other major strike prices below current Brent and WTI futures levels have also increased sharply so far in 2016.

“Price moves are always exaggerated and go further than logic says, so a crude oil price below $20 and down to $10 is not impossible technically,” oil trader Berentsen said.

Analyst downgrades have also fueled bearish sentiment, with several banks cutting their 2016 oil price forecasts this week, including Standard Chartered, which said prices could drop as low as $10 a barrel.

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