Market Extra: Emerging-market currency bulls are betting oil’s gains can be sustained

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As oil trades near three-year highs, investors are starting to wonder whether buoyant oil prices, which have a direct effect on the currencies of oil rich countries, can be sustained.

West Texas Intermediate crude oil for February delivery, the U.S. benchmark, CLG8, +0.85% at around $64 a barrel, and Brent oil, the international benchmark, approaching $70, have both surged to their highest levels in more than three years over the past several weeks.

Major supply disruptions and optimism over the Organization of the Petroleum Exporting Countries’s efforts to a tamp down a dogged glut of oil that had delivered a lasting blow to oil futures, combined with a recent bout of Middle Eastern conflicts, have helped crude to mount a weekslong breakout.

The currencies of oil-rich countries have benefited from the rally in crude and the upward price trend in other commodities. Among the beneficiaries of the uptrend are emerging-marketcurrencies like the Russian ruble USDRUB, +0.2217%  which has climbed 1.6% relative to the U.S. dollar since Sept. 1 when the crude rally picked up speed, or the Malaysian ringgit USDMYR, -0.0251% which jumped 6.7% against the greenback in the same period.

But Brazil, also an oil producer, has seen its currency, the real USDBRL, -0.2612% weaken 2.3% against the dollar since Sept. 1. That said, Brazil is facing its own set of domestic issues, including a precarious fiscal situation that lawmakers are seeking to rectify by reforming the pensions system. On Thursday, S&P downgraded the country by one notch to BB- on those grounds.

Brazil isn’t the only oil-rich developing country that is largely driven by headlines unrelated to the commodity. Venezuela, for example, is embroiled in fiscal catastrophe and a humanitarian crisis, while strategists pay little attention to the Venezuelan bolivar USDVEF, +1.0506%  anymore.

At the same time, emerging markets ETFs, such as the Vanguard FTSE Emerging Markets VWO, +1.01%  or the iShares MSCI Emerging Markets fund EEM, +0.95% have registered significant gains over the past year, rising 29.64% and 34.57%, respectively over the past 12 months, according to FactSet.

To be sure, EM countries also have enjoyed an extended period of dollar DXY, -0.99% weakness that also has supported an updraft in the price of dollar-pegged assets like oil, because a softer dollar can encourage purchases from buyers using weaker monetary units.

But some analysts harbor concerns about how long oil can maintain this recent resurgence.

Lukman Otunuga, research analyst at FXTM said that “while further upside is still on the cards amid the current market optimism, it must be kept in mind that rising production from U.S. shale has the ability to expose oil to downside risk.”

Read: Here’s how oil, industrial metals could trade in 2018

Additional supply coming on line could expose oil to downside risks and could filter through into currencies.

“That’s always a risk,” said Win Thin, EM currency strategist at Brown Brothers Harriman, of a potential reversal in oil prices that could unsettle emerging markets. “That said, the EIA just raised its 2018 price forecast for WTI and Brent this week and lifted U.S. output projections.” EIA refers to the U.S. Energy Information Administration, a federally backed energy-data agency.

Scotiabank EM Asia currency strategist earlier this week emphasized a call for further strength for Malaysia’s currency.

“We maintain our short dollar-ringgit position with a target of 3.90 as the ringgit is still cheap,” wrote Scotiabank’s EM Asia currency strategist Qi Gao earlier this week, referencing rising oil prices as well as Malaysia’s rampant industrial production growth, which jumped 5% year-over-year in November. One dollar last bough 3.9770 ringgit on Friday.

The EIA lifted its WTI target to $55.33 per barrel in 2018, $4.85 above its December forecast, and to $57.42 for 2019. Meanwhile the output expectation was lifted by almost 3% to 10.27 million barrels a day.

The strategist sounded mostly upbeat about the prospects for emerging-market economies, due to a global economy that is improving in tandem and should prove positive for EM countries.