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Crude oil has had a strong largely-bullish run over the past year or so. As the world emerged from the pandemic-induced movement slump and 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 Arca 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%:
Over the past week alone, the drop was a staggering 8.4% – which was followed by a further 3% drop as of the 22nd.
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”.
Banks typically borrow overnight loans from each other to meet liquidity requirements mandated by regulators. The average of the interest rates banks assign for these loans is called the “effective federal funds rate”. This rate is influenced by the target rate. As a result, loans become more expensive for economic participants – be they merchant or consumer – interest payments increase. 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 take a dip. This is clearly evident in patterns in abrupt shift in crude oil trajectories over the past years in the pre-pandemic era.
However, it bears noting that “dovish” moves by the Fed – meaning small changes in the rate – do little to address extensive inflationary momentum. For instance, it took significant amounts of U.S. government assistance through the Troubled Asset Relief Program (TARP) wherein large amounts of debt, mortgages and even shares of troubled companies were purchased to “promote financial stability” before inflation settled briefly in a downward trend. Crude oil prices followed this downward trend to a point before galloping away again (and with it inflation rates).
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 (i.e. inflation); 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. This has been seen to have some peculiar effects: for instance, service jobs in the U.S. – restaurant workers, delivery drivers and other hourly wage earners – are thus disincentivized more and more from participating in economic activity while burning through savings and COVID-era allowances provided by the government: if the means to earning money results in loss of savings or no substantial change in spending/saving opportunities, then – reasoned a substantial number of Americans – there is no point in working. This phenomenon has been dubbed “The Great Resignation”.
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 despite crude oil prices seemingly poised to continue trending upwards.
Over a course of 10 days, i.e. June 10th till June 17th, the S&P 500 fell by 12%, the largest fall in the year so far. 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 S&P 500’s level as of the 17th was 10% below its 50-DMA.
Meanwhile, energy sector constituents within the S&P 500’s 50-DMA Spread – the difference between the upper and lower limits of the 50-DMA – was a little more than 10%.
In the past one week alone, the number of energy companies’ stocks above their respective 50-DMA has gone from 100% to zero.
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.
All in all, this is a very complex situation that brings about a lot of uncertainty, that will almost certainly create significant volatility in crude oil prices in both the upside and downside beyond the historical effects of the Fed rate hike. Disciplined investors who are savvy to news and developments can likely find many short-term tactical opportunities in the situation that can potentially boost their portfolio returns, if they play their cards right.
Your capital is at risk if you invest. You could lose all your investment. Please see the full risk warning here.
Sandeep joined Leverage Shares in September 2020. He leads research on existing and new product lines, asset classes, and strategies, with special emphasis on analysis of recent events and developments.
Sandeep has longstanding experience with financial markets. Starting with a Chicago-based hedge fund as a financial engineer, his career has spanned a variety of domains and organizations over a course of 8 years – from Barclays Capital’s Prime Services Division to (most recently) Nasdaq’s Index Research Team.
Sandeep holds an M.S. in Finance as well as an MBA from Illinois Institute of Technology Chicago.
Violeta joined Leverage Shares in September 2022. She is responsible for conducting technical analysis, macro and equity research, providing valuable insights to help shape investment strategies for clients.
Prior to joining LS, Violeta worked at several high-profile investment firms in Australia, such as Tollhurst and Morgans Financial where she spent the past 12 years of her career.
Violeta is a certified market technician from the Australian Technical Analysts Association and holds a Post Graduate Diploma of Applied Finance and Investment from Kaplan Professional (FINSIA), Australia, where she was a lecturer for a number of years.
Julian joined Leverage Shares in 2018 as part of the company’s premier expansion in Eastern Europe. He is responsible for web content and raising brand awareness.
Julian has been academically involved with economics, psychology, sociology, European politics & linguistics. He has experience in business development and marketing through business ventures of his own.
For Julian, Leverage Shares is an innovator in the field of finance & fintech, and he always looks forward with excitement to share the next big news with investors in the UK & Europe.
Oktay joined Leverage Shares in late 2019. He is responsible for driving business growth by maintaining key relationships and developing sales activity across English-speaking markets.
He joined LS from UniCredit, where he was a corporate relationship manager for multinationals. His previous experience is in corporate finance and fund administration at firms like IBM Bulgaria and DeGiro / FundShare.
Oktay holds a BA in Finance & Accounting and a post-graduate certificate in Entrepreneurship from Babson College. He is also a CFA charterholder.
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