A long time ago, in a market far far away, oil was a hot commodity. Investors expected prices to reach $200 without breaking a sweat. Unfortunately there wasn’t a happy ending, but fans of that story should read this article closely.
Following the Fed’s announcement on Wednesday to buy $300bn of US Government debt, traders rushed to commodities to protect themselves from inflation. In doing so, they pushed NYMEX crude above $50 for the first time since December. Could this signal A New Hope for oil investors or should they beware the Return of the Bear?
The rally is fuelled principally by economics 101: Publishing money in huge amounts will lead to rampant inflation and a devalued dollar. When the American Treasury buys treasury bills and bonds, it is exchanging cold hard USD for dollar denominated securities. If we consider dollar supply and demand, the treasury has effectively shifted the supply curve rightwards and created a lower ture (equilibrium) price for dollars. With dollars worth less, we need to pay more to buy imported goods and materials. To afford these prices, workers demand wage increases, leading to more dollars in the system, which leads to an even lower exchange rate, which leads to even higher prices and soon we’re locked in to serious inflation.
Traders, to prevent getting caught in the inflation trap, have recently started moving out of dollars and in to commodities. This week saw the fifth consecutive increase in oil prices, gold has increased 8% since Wednesday and the Reuters/Jefferies CRB Index, which tracks a basket of 19 commodities, is up 11%.
Clearly, Wednesday’s announcement caused bullish sentiment, and even looking beyond monetary policy we see greater confidence in oil. OPEC’s December 17th cuts were initially disregarded by the markets, but are finally being taken seriously due to OPEC countries like Nigeria working together to stick to their quotas. Venezuela’s Hugo Chavez nationalized the local unit of Spanish banking conglomerate Group Santander, and governmental power plays usually put oil traders on edge. Further, as the April contract reaches expiry we may see traders caught in a short squeeze pushing up prices, much like we reported in October of 2008.
Looking at next week, can we expect the bulls to keep charging? Two considerations: First, demand. We mentioned earlier that a rightward shift in the supply curve of dollars would lead to a weaker dollar. Similarly, a leftward shift in the demand curve for oil would lead to cheaper oil. And we’re seeing very very weak demand for both crude and finished products like gasoline. Unless the economic condition picks up, metals stand to gain more from the commodity boom than energy.
Secondly, and in the longer term, a weak dollar hurts OPEC because of dollar denominated barrels. So we may see an announced increase in production or, more likely, individual countries will start ignoring their quotas and increasing output to make up for lost revenue.
It’s a pleasant change to see investors converging on oil after almost a year of bearish sentiment. If you know what you’re doing, you could pick upon increased arbitrage opportunities as retail investors often ignore the fundamentals. But remember, the market can stay irrational longer than you can stay solvent, and although Oil Energy Money is feeling bearish, the force is definitely with the bulls this week.
