After a precipitous decline from US$100/bbl in September 2014, brent crude oil has settled into a trading range of $48-$50 in the last couple of weeks. The pressure appears to remain to the downside, after Saudi Arabia decided to leave its oil policy unchanged under the leadership of the new King Salman bin Abdul Aziz. Ongoing demand remains weak against a supply glut.
The oil price is also highly negatively correlated to the US dollar index, as shown in the graph below. This negative correlation has steepened in the last 12 months.
This has clearly been a consistent theme for major commodities.
The US dollar index increased 1.6% over the last week. Major drivers were the weaker EUR/USD and higher USD/CAD following last week’s announcements of a euro $60 billion/month bond buying program by the ECB and the 0.25% point official interest rate cut by the Canadian central bank.
The simple statistical relationship between the US dollar index and the brent crude oil price would suggest a drop in the crude price around $4.70-$6.80 given the 1.5 point increase in the former over the last week. In fact the crude price remained virtually flat over the week.
Our fair value model extends this type of analysis by considering 22 driver variables of the oil price (including the US dollar index). We find that the fair value of brent crude oil dropped $6.70 over the week. Based on the flat price movement, this implies short term downside in the oil price.
Over the last 90 days, trading brent crude as dictated by the relative movement in price vs fair value as discussed above, an annualized gain of over 100% with volatility of 30% would have been achieved.