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The Push for a Stronger Dollar

A piece I wrote yesterday....

US dollar's key role in oil drama
Oil up, US dollar down. Or is that oil down, US dollar up?
The past week has demonstrated just how important the dollar/oil polka has become.
Oil's recent stratospheric surge has become the market's dominant investment driver. It's becoming a threat to economic activity and has raised the very real spectre of 1970s-style stagflation.
The pain of a $US135-plus price has highlighted just how inelastic oil's demand profile can be - at least in the short term. But the increasingly vociferous howls of protest from consumers suggest that "demand destruction" is at last starting to bite.
It's been interesting watching the market response to the latest round of price rises. There is a view that what we are experiencing is somehow unique - or at least, not something we've seen since the oil shocks of the 1970s.
But how accurate is this? Let's take a quick recap.
Over the past three months, oil has jumped 58 per cent. In just over four years, it has risen 240 per cent. Pretty remarkable.
But, then take a look at the market in the four years prior. In October 2004, when oil hit a record high of $US55, it had just completed a three-month, 55 per cent rise. In the preceding three years it had risen 218 per cent. Sound familiar?
So this takes us back to December 2001. What of the prior period? In September 2000, oil had peaked at $US37. This happened to follow a five-month, 55 per cent price rise. And a 247 per cent rise from its 1998 low of $US10.72 a barrel.
So investors should be used to the quantum of these moves.
But the fact that they're not, and that this one is creating some very real pain, suggests we may at last be testing the market's choke point - the point at which price does indeed trigger a significant consumption response.
In 2004, when the market "adjusted" to then-record prices, we saw a 27 per cent correction back to $US40 - the launch point for the current price run.
In 2000, prices eased 30 per cent over the first few months following the September peak. By way of comparison, were we to now see prices fall back to around the $US100 level, this would equate to a 27.5 per cent correction.
How realistic an expectation is this? Three inputs would be needed to precipitate such a price response: increased supply, decreased demand and a strengthening US dollar.
Saudi Arabia has again led the way on a possible supply response. This week, Saudi Oil Minister Ali al-Naimi called for a meeting between consumers and producers over "how to deal with record prices".
Given Saudi Arabia has some 2 million barrels a day of spare production capacity, it has a key input into any price correction.
But also, expect pressure on the US government to consider "targeted" sales from its 727 million barrel US Strategic Petroleum Reserve. This has been utilised as a safety valve in the past - most recently after supply disruptions that followed Hurricane Katrina.
On the demand side, apart from declining US and European off-take, expect mounting pressure on China to begin a phased reduction in its fuel price subsidies. Without this, there will be no consumption response from the second-largest oil importer.
But the biggest impact on prices could come from a meaningful move on the US dollar.
After the setback of European Central Bank president Jean-Claude Trichet's rate rise comments, the focus has returned to what appears to be a concerted effort by US authorities to lift their ailing currency.
The week began with US Treasury Secretary Henry Paulson hinting that active currency intervention was being considered.
"I would never take intervention off the table, or any policy tool off the table," he said.
This followed comments last week by US Federal Reserve chairman Ben Bernanke that he was working with Treasury to "formulate policy" that would prevent the dollar from declining further.
From a Fed perspective, this implied that US rates were at best "on hold", the next move more likely to be up.
This view was reinforced on Monday after New York Federal Reserve president Tim Geithner indicated that "tighter monetary policy" may be needed globally.
On the issue of recent US dollar weakness, he pointedly added that "no government, nor central bank, can be indifferent to changes in the value of its currency".
Completing the pro-dollar jawboning, US President George Bush was interviewed ahead of the US-European Union summit in Slovenia. He indicated that he would be telling the summit of the need for a strong dollar.
"We want the US dollar to strengthen," he said, adding that "relative evaluations of economies will lead to that dollar strengthening".
He received unlikely support from OPEC president Chakib Khelil.
"The economic crisis in the US caused the US dollar to drop sharply and the threats against Iran heightened geopolitical tensions. If it wasn't for these factors, the price of oil would probably be $US70," he indicated.
All told, plenty of talk. The market will now be waiting to see how this converts into action.