Stay both commodity and dollar bullish in 2017 – Goldman Sachs

Research Team at Goldman Sachs explains that as the dollar is the numeraire for oil, commodities and global trade, higher oil prices create excess savings in dollars which weigh on the dollar and vice versa when declining oil prices reduce excess savings. 

Key Quotes

“We find that statistically if the change in oil price leads to a change in excess savings, then there is a negative correlation between the price of oil and the dollar.”

“Therefore, there are two ways to get positive commodity returns in a bullish dollar environment. The first is to break the correlation between the dollar and oil by breaking the correlation with oil and excess savings. The second is for returns to be generated solely from backwardation without price changes, for which there is precedent for in the late 1980s and mid 1990s, an environment that has been likened to the upcoming environment. We believe that both forces will likely be at work in 2017:

• While we expect commodity prices to rise, we do not see them rising by enough to significantly change the financial pressures on EM producers. In a world where $50/bbl to $55/bbl oil now looks to be the long-run equilibrium price, there are no excessive windfall gains to be saved by commodity producers. Rather commodity income is more likely to be seen as permanent income and hence spent immediately, helping to finance both fiscal transfers (which remain much higher than in the last phase of the commodity supply cycle) and efforts to diversify excessively commodity-centric economies;
• Our more optimistic outlook for commodity returns during 2H17 is driven to a large extent by “roll returns”. The benefit of this return is not seen by the commodity producer (who sells longer dated options), or the commodity consumer (buying near the front of the curve), but rather the investor who assumes the risk in transferring between the two. Since roll returns are highly dependent on the level of inventories, and the willingness to hold inventories is itself a function of the cost of holding these inventories and hence funding costs, as interest rates rise with a cyclically stronger backdrop the amount of inventory held should decline, boosting commodity roll returns – even as the US dollar appreciates due to higher real interest rate differentials. We expect that the positive roll return from backwardation will offset the downward pressure from a strengthening dollar, as has historically been the case.”