The OIL cartel meets today, and the market is expecting it to extend the period of production cuts by an extra nine months, through to March 2018. This has been widely signalled after Russia (a non-Opec member) and Saudi Arabia said that they would support an extension of the cuts last week.

There is a very small chance that some of the smaller, struggling members of Opec, including Venezuela and Nigeria, may resist the prospect of further cuts, overall we think that Saudi Arabia will ultimately get what it wants from this meeting.

More upside for oil?

The oil price has risen more than $3 on the back of the leaked details ahead of the meeting. We think that if this extension to the production cut is agreed then we could see further upside for oil, as the market prices in an even more prolonged cut perhaps further into 2018. It is worth noting that after the first production cut was agreed in November 2016, the oil price crept higher for more than a month, with Brent crude rising some $6 in the aftermath of that meeting.

A confluence of factors could boost the price of oil in the short term including: decent expectations for global growth, low volatility, and the expected Opec production cut. If this happens then Brent crude could drift back towards $60 per barrel, the highest level since 2015, with WTI potentially moving back towards $55, the highest level since late February.

Oil market dynamics and FX

A higher oil price can impact the FX market in two ways: firstly it can put upward pressure on inflation expectations, which can impact a currency’s yield differential; and secondly it can have a direct impact on the attractiveness of the so-called “commodity currencies” and the commodity import currencies.

We have done some correlation analysis looking at the relationship between the Brent and WTI crude prices and some FX pairs, including the traditional commodity currencies: the CAD, NOK and AUD. I have also looked at the yen, because Japan is a large commodity importer.

The conclusions that we have found are as follows:

  • The Cad tends to have the strongest long-term correlation with the Brent and WTI oil prices, and moves with the oil price 56% and 57% of the time, respectively.

  • The NOK and AUD have insignificant short and long-term correlations to the Brent and WTI prices.

  • Interestingly, the CAD and the NOK are highly correlated, and they have moved together 60% of the time since the start of the year. Thus, if the CAD moves on the back of a change to the price of oil, watch the Nokkie as it may follow suit.

  • Unsurprisingly, the yen has a negative correlation to both the Brent and WTI oil price in the longer term. However, since the start of this year the correlation has dwindled back to zero, possibly reflecting the yen’s status as a safe haven that has been tested by a number of geopolitical events in recent months.

We also think that it is worth watching the dollar. Since a barrel of oil is priced in dollars, the dollar and oil tend to move in opposite directions, but not by as much as you may think, in fact since the start of this year the correlation between the dollar index and WTI has been a mere -0.1%.

If today’s Opec meeting does lift the price of a barrel of oil then we could see US inflation expectations rise, which would be supportive of a more aggressive pace of tightening from the Federal Reserve, and that could be dollar positive, especially vs. the yen. With the dollar index continuing to linger at its lowest levels since November 2016, perhaps a stronger oil price could be one way to lift the buck out of the doldrums?

As a side note, it is worth noting that President Trump said earlier this week that the US could sell off part of its Strategic Petroleum Reserve (SPR) to fund the US deficit. This has had no material impact on the price of oil, after all the plan is vague at this stage and may never see the light of day as support for this measure would have to get passed by Congress. However, if this becomes a theme in Washington (and it’s a big if), then it could dilute some of the potential positive effect from today’s Opec meeting, and may weigh on the price of oil in the longer term, which could have knock-on effects for the FX market.

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