Oil could fall to high $20s due to dollar strength, Morgan Stanley says

“Given the continued USD appreciation, $20-25 oil price scenarios are possible simply due to currency,” a group of the broker’s commodities analysts said in a research note sent to clients.

More specifically, in the broker’s opinion the main reason why oil futures dropped from $55 to $35 was the strength in the trade-weighted value of the greenback, not in the US dollar index, given the inverse relationship between the two.

Recently, the rolling 20-day and 30-day betas for the weighted USD basket of currencies had generally ranged between two to four and at some times exceeded a value of four, it explained.

In other words, for every 1% move up or down in the trade-weighted US dollar you tended to see a movement of between 2-4% in the price of Brent oil, Morgan Stanley said.

Hence, should Chinese authorities opt for a swift depreciation in the yuan of 15% (the yuan makes up 21.5% of the USD's trade-weighted basket), as a Reuters recently suggested, that alone could send oil into the high $20s.

In turn, such a move could prove even greater should moves in other currencies reinforce the move, the analysts believed.

“Hence, we remain bearish, even after the notable downward move already,” they said.

Policy insiders in Beijing had begun calling for a “quick and sharp” depreciation in the yuan (although whether they meant against the US dollar or in the trade weighted yuan's value was not clear), together with capital controls, to brake speculation and capital flight from the country, Reuters reported on 8 January.

A slow depreciation, on the other hand, was seen by those same insiders as doing more harm than good.

However, one government researcher said - again, without specifying if he was talking about the dollar/yuan exchange rate or the yuan's trade weighted exchange rate - Beijing was unlikely to allow the yuan to weaken by the "at least" 10% necessary to have an impact on exports.