Oil (Brent Crude) has been among the strongest performing commodities this year, as shown in the graph below.
Last week saw continued strength, in the face of a significant downward move in oil’s fair value over the week. The drivers of this are analyzed in the graph below:
Such a disparity between fair value decrease and price increase would normally be a signal to go short oil. Taking positions based on disparities between fair value and price change over the last 90 days would have yielded an annualized gain of 169% with volatility of 40%.
Our assessment of oil’s fair value lies well below the current price, suggesting that the commodity is overvalued on fundamentals. However taking positions in oil based on this signal of under/over valuation would have generated negative returns over the last 90 days – hence we are inclined to use caution when relying on this indicator.
We have also developed a signal based on the lead given by the change in the Baltic Dry Index (BDI) of raw material shipping freight rates. This index is widely seen as a leading indicator of world economic growth, with increases seen as bullish and conversely. Based on the relationship between the BDI and oil price over the last six years and the 11% drop in the BDI over the last month, a short term decrease in the oil price can be seen as likely.
Trading this signal would have yielded a 16% per annum gain with volatility of 27% over the last six years.
Relationship to USD and volatility
The graph below shows the sensitivity of oil’s fair value to various drivers.
As can be seen, oil is negatively correlated to the US dollar. Our fair value indicators suggest some short term upside in the US dollar index which would be bearish for oil.
The USD may undergo some volatility this week if the PMIs and/or jobs data comes in at some distance from consensus. Given the high sensitivity of oil to the USD evident in the above graph, this could translate into volatility in the oil price.
Looking back over the last three years at oil’s price changes for the week leading up to the nonfarm payrolls print, we find a volatility of 29% vs. volatility for all weeks over the period of 22%.