Oil ETFs: What if the Dollar Strengthens?

It's no secret that surging oil prices are hammering consumers. It's also contributing to higher living expenses, also known as "inflation."

In Fed Chairman Bernanke's speech in Spain this week, he sent a strong message to the world that the Fed would be shifting its focus to rising prices for food and energy. Put another way, the Fed's finished lowering interest rates to ward off a housing-induced recession; rather, it will look to keep the economy stable by monitoring the increasing costs of living.

It is doubtful that the Fed can directly reduce the supply and demand of commodities like food, metals and oil; that said, stabilizing interest rates increases faith in the U.S. dollar. (Read more about the fate of the U.S. dollar here.)

Indeed, the dollar has been stabilizing since the final rate cut by the Fed on April 30. Here is a chart of the PowerShares DB US Dollar Index Bullish Fund (UUP) since the last Fed move, compared against the CurrencyShares Euro Trust (FXE) and the PowerShares DB Agriculture Fund (DBA).

Indeed, one can draw a line straight through the middle. Since the dollar has flattened, it is faring well against the Euro and food.

However, oil has risen yet another 10% since April 30. This suggests that, while there is a relationship between the price of oil and the dollar, it is not the only relationship. Speculation vis-a-vis Goldman's $200 barrel call and Pickens' $150 call plays a part. What's more, genuine supply and demand have played a huge role in the run from $40-$50 to $135+.

Steve Liesman of CNBC recently pointed the supply-and-demand fact out with a statistic that showed the price of oil doubling in places like Europe, as it has tripled in the U.S. Of course, that's when Rick Santelli of CNBC counter-punched, pointing out that a 200% rise in parts of Europe compared to a 300% rise domestically suggests roughly a third of oil's rise may be dollar-induced.

Clearly, there is a relationship between the value of the U.S. dollar and oil prices. Worldwide, crude has been priced in U.S. Dollars for 3 1/2 decades. So when the dollar falls, oil prices rise via a phenomenon that many dub, "petrodollar inflation."

Now comes the interesting part. Recently, governments around the globe that had been keeping fuel prices artificially low have been allowing them to rise gradually. This saps oil demand. Higher prices have already been siphoning off demand. Meanwhile, OECD inventories and increased OPEC production suggest greater supply. With supplies rising, and short-term demand falling, the only thing to push Oil ETFs higher are rampant speculators and a weak dollar.

Enter a more stable U.S. dollar, or even a strengthening dollar. Now the only thing to keep egging the oil boom on in the near-term is the desire of speculators to make money on the long side.

Don't bet the farm. Granted, the world will not move to transitional and alternative energies overnight. Even a practical 5-7 year assessment on oil may be one in which prices are still elevated.

In the near-term, however, one should be prepared for the possibility of a dramatic pullback. With magazine covers like The Economist featuring a picture of a stamped barrel ($135), and with CNBC putting a special ticker of crude in the lower-hand corner of its screen for 24/7 viewing, one is reminded of Nasdaq coverage in 1999.

If you're long the United States Oil Fund (USO), keep your stop-losses in place. If you see the potential for a 40% pullback, similar to the one that occurred in 2006, you might be aggressive with ProShares UltraShort Oil (DUG). But that's an ultra-speculative play requiring stop-loss protection as well.

In truth, if the dollar strengthens, it could mean trouble for "commodities-can-only-go-up" investors. Time to take off the blinders.

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Comments

[Aly-Khan Sa...:]

It is highly unusual for The Fed to comment on the $ and I think it reflects a degree of concern that $ shorters need to take notice of.
Paul Volcker also recently broke with form to say that there was a $ crisis. So I feel that the $ can rally substantially from here. In that context, it would be a little foolhardy to stand in front of what might very well become a freight train in the Crude markets.

This is not the time to be limit long Crude.

Aly-Khan Satchu
rich.co.ke

2008 Jun 05 05:10 AM

[DONE_SONZ:]

You guys are the ones that need to take off the blinders.Oil isnt up because of speculation and the sweakness or the strength of the dollar.Give at rest already.

2008 Jun 05 08:30 AM

[fxtrader07:]

DUG is a poor play on declining crude prices.
many oils stocks haven't caught up to oil at 130$/bl yet but are instead priced for oil at substantially lower levels. the stock market so far has refused to accept 110$ oil as a lasting reality, not to speak of 130$
@gorilla: there are sound arguments for the structural strength of oil. still, none of these arguments can underpin any specific "fair" price of oil. it may be 100$ or 130$ or 180$? who knows?
what is important to see, though,. there are factors at work against an endless rise in oil prices, too. oil is used for electricity generation, as fuel and for making all sorts of stuff.
when you can't raise the price for fuelö anymore because people drive much less or use other transport alternatives, fuel consumption will decline and demand from that side, too. the same goes for chemical products. if producers can't pass the higher oil prices to customers, priction will go down, and so will demand.
oil demand and supply are highly inelastic in the short-medium term, but that doesn't mean that they do not at all respond to demand destruction or supply destruction. they do.
and so, even oil is NOT going up in a straight line. and if demand goes down considerably due to more efficient use (burning oil for instance, is simply a crime imho) you may well see a period coming when prices go down considerably despite all peak-oil talk. that is because, supply is highly inelastic too. such sustained decline won't happen anytime soon, though. but maybe 10 years from now it could.

2008 Jun 05 09:27 AM

[Greg Pinelli:]

DUG is a poor play on declining crude?? fx didn't give one REASON why DUG is not a worthy way to hedge the price of crude. Lots of mispeeled remarks about why crude is higher or staying higher (though this is a bit like deciphering poorly written hieroglyphics) but NOTHIN about DUG..in reality,
The DUG idea is excellent..in fact the entire article is so far above the Alpha cut its hard to imagine it was published. DUG has been very profitable this week...look at the 52 week chart..DUG made a very prolonged low..not a parabolic one...oil is cracking.
Now..oil and gas may not crack for long....$100-110 base is not only reasonable..it's all the jawboning will take the US$..and the bottom line on crude..it's the Geology..not the speculators.

2008 Jun 05 09:54 AM

[crimfunk:]

DUG is not a good proxy to short oil. DUG shorts $DJUSEN x2 which is made up of E&Ps, OIH companies the drillers, Refiners, and NG Plays. For DUG to trade well all four must come down at the same time. While crude may drop the E&Ps, refiners have bottomed and are rising with the crack spreads, NG demand hasn't stopped, and driller will perform with continued demand.

2008 Jun 05 11:21 AM