Oil And The Dollar

Crude Oil prices broke down from $100+ about a year and a half ago. Since then, there has been minimal fallout in the US oil patch, mostly due both to price guarantees built into many contracts and to the availability of loan money.

As the price of oil still lingers in the $30 range (today at $33+), and as all that borrowed money carries interest which must be paid, oil shale producers will start to be pinched more and more this year.

Some shale oil companies will close up shop this year, and some banks with huge oil company non-performing loans also will go bankrupt. And let’s not forget the collateral damage to quite a few others businesses whose sales depend on the soon to be out of business companies.

Production will be lost, at least until the price of oil rises a bit. Then there are producers which will run their wells until they’re dry (shale oil wells have a relatively short producing life span). If oil prices remain low, these producers will not replace production right away, so some additional supply decreases will occur.

The cutbacks over the next year or two will be offset by new supply elsewhere, for example Iran as they resume selling oil following the end of sanctions.

So, what could cause oil prices to rise, saving the bacon of the marginal US shale oil producers?

One possibility, both directly and indirectly, is a reversal of the soaring US Dollar, which rose over 20% during the 2^nd half of 2014.

Without that rise in the Dollar, oil might be 20% higher than today, or a little over $40 a barrel.

The rise in the Dollar itself was caused in part by the Yen carry trade. As the Japanese Economy foundered, and as the Central Bank kept interest rates significantly lower than the FED did here in the US, speculators were able to borrow in Yen, using the Yen to buy Dollars. Those Dollars bought Treasuries and US stocks, helping to explain rising markets last year.

US markets rose to unsustainably high PE Ratios, at the same time that the rising Dollar was hurting corporate profits. US multinationals’ overseas profits, while still growing in the local markets, started falling in US Dollar terms. The “strong” Dollar also made US domestic companies less competitive with imports, cutting sales and profits.

High PE Ratios, together with falling profits, are a recipe for a severe pullback (50% or more) in US stocks. Falling expected returns on all that borrowed money likely will cause considerable unwinding of much of the Yen carry trade. As the Dollars are withdrawn from US markets to buy Yen to repay the loans, the Dollar will fall.

Assuming the Congressional Republicans keep their word and refuse Mr Obama’s proposed $10 a barrel oil tax, I expect the falling Dollar to raise the oil price to make many proposed shale projects profitable.

So, for 2016, expect:

• A few oil producer bankruptcies
• A couple of banks with oil patch exposure to fail
• The US markets to fall quite a bit further from here
• The US Dollar to fall 20% or so
• The oil price to go up over $40

All this does not factor in any additional craziness coming out of Washington (and the FED), or collateral damage from a market crash. We certainly could see quickly rising unemployment and CPI numbers, even after the hacks in the agencies massage the numbers.