It all started so well. Oil prices rose to a two-week high in the early part of last week on the back of tightening oil inventories. Yet the feel-good factor did not last. Supply and demand factors subsequently took a back seat to US inflation worries. Indeed, the risk asset complex was sent into reverse as US consumer prices in the 12 months through October accelerated to 6.2%. That was the largest annual gain since November 1990. This, in turn, spurred expectations that the Federal Reserve will accelerate plans to boost interest rates to tame inflation. Cue a rally in the dollar. The US currency surged to a 16-month high against a basket of its major peers and ultimately notched its biggest weekly rise in five months. The strong dollar took the edge off the oil market. Brent and WTI fell for a third consecutive week with the former shedding 0.7% and the latter declining 0.6%.

The bullish party was also spoiled by the prospect of more supply reaching the market. Up until now, the Biden administration has not followed through with threats to take action to address surging oil prices. However, with inflation heating up again, which incidentally is driven largely by steeper energy prices, Washington might soon opt to release more strategic crude stockpiles to drive down prices. Sure enough, on Friday the US government reiterated that it continues to look at “every tool in our arsenal” to blunt gasoline prices. This was followed by calls from the Senate Majority Leader Chuck Schumer “for immediate relief at the gas pump”. In short, speculation is building that the White House could tap its Strategic Petroleum Reserve any day now.

All the while, adding a further downer on the oil market last is a resurgence of Covid-19 infections in Europe. According to the WHO, it is the only world region where cases and deaths are steadily increasing. Small wonder, then, why governments are taking action to stem the surge in infections. On Saturday, the Netherlands became the first western European country since the summer to impose a partial lockdown. From today, Austria is introducing mobility restrictions on the unvaccinated. Meanwhile, Germany is said to be considering imposing fresh Covid restrictions, after the country recorded its highest ever infection rate over the weekend. The spectre of a fourth wave of the pandemic is hanging over the continent and risks throwing a spanner in the works for the global oil demand recovery. The return of the dark days of Covid coupled with a perky dollar is putting the brakes on the oil price rally. That said, markets are still tight. Global oil demand is exceeding supply right now. Even so, judging by last week’s price action, Brent faces an uphill battle to break above $90/bbl before the year is out.

The gloves are on

Clearly, higher inflation is becoming problematic for Washington. The latest inflation reading released last week is light years above the Fed target of 2%. Such is the seriousness of the situation President Joe Biden was quick to call for tackling inflation his top priority. For its part, the US central bank argues that the factors pushing up inflation are expected to be transitory. Yet this narrative is losing credibility as each day goes by. Inflation is proving more sticky than officials predicted a few months ago and is unlikely to recede before next year.

Surging US inflation is making the case for tighter monetary policy. Earlier this month, the Federal Reserve began tapering its pandemic stimulus package. The dialling back in its bond purchases is the first step in a process that would ultimately lead to interest rate hikes. Even so, many still think the Fed is behind the curve in curbing inflationary pressures and will be forced into hiking rates sooner rather than later. Expectations are now running high that the FOMC will sound a bit hawkish during next month’s meeting and lay the foundations for a rate hike early next year. In anticipation, market players are aggressively bringing forward rate hike expectations for 2022.

The march towards monetary tightening is underpinning a rejuvenated dollar. Dollar bulls put their boxing gloves on last week in the wake of the October CPI blowout as it crossed the 95.00 threshold. New milestones are on the cards with a lurch higher towards and even beyond the 96.00 barrier. Simply put, the bullish bias will remain intact for the dollar index as we approach the inevitable Fed rate hike. Consequently, oil market players will have to get accustomed to a firmer dollar in the coming months.

This spells bad news about the immediate prospects for prices. After all, a strengthening dollar makes oil more expensive for holders of other currencies. This phenomenon is already plain to see. Brent has rallied 15% since the start of September but this figure rises to 18% in euro terms. The situation is even more pronounced in the developing world.  Brent priced in Brazil’s real has gained 22% over the period while the figure rises to 23% in the case of South Africa’s rand. These adverse currency swings are having a meaningful price impact across non-dollar economies. And the situation is set to intensify as the greenback builds on its strength in the coming months. In conclusion, Uncle Sam’s currency remains in the driver’s seat and new highs should materialize over the medium term, much to the chagrin of those betting on higher oil prices.