Tumbling dollar bolsters oil's push to new highs

Continued drop could mean record highs for dollar-based commodities

By Moming Zhou, MarketWatch

Last update: 12:01 a.m. EDT March 11, 2008

SAN FRANCISCO (MarketWatch) -- Oil, a dollar-denominated commodity that has reaped big gains from the greenback's recent tailspin, is likely to keep pushing higher as the dollar continues its slide, say analysts.

If the dollar keeps falling -- a scenario likely to happen if the Federal Reserve cuts interest rates further, and if funds keeps building up in commodities market -- the prices of oil and other dollar-bases commodities such as gold could break new records in the short term, analysts said.

"Unless the dollar can stage a major recovery," or the oil market sees waning interest from funds, fewer geopolitical risks or threats from an economic slowdown rise, "the market's trend will likely remain up," said John Kilduff, an analyst at futures brokerage MF Global, in a recent report. "An eventual move to the $110 to $115 price range can't be ruled out," he said.

"The dollar is likely to fall as the Fed is seen to cut interest rates further, and this could push up oil prices even higher," said Darin Newsom, senior analyst at DTN, a commodities information provider in Omaha. "I am seeing oil rise to the range of $109 to $115" a barrel, he said.

Some analysts are making even bolder calls. In a recent report, Goldman Sachs says $200 a barrel could be a reality in the near future if an unexpected factor emerges, such as a major supply disruption.

"A future rebound in U.S. gross domestic product growth or a major oil supply disruption could lead to $150-$200 a barrel oil prices," Goldman said in a report released on Friday. See full story.

As the U.S. dollar has repeatedly hit record lows against the euro, oil prices have surged, topping $108 a barrel on Monday.

Increased speculation

The oil market has seen unusual run-up recently. Last Wednesday, oil rallied $5 a barrel, the biggest daily gain in value since crude futures started trading on the Nymex in 1983. Crude has risen nearly $20 in just one month.

Gold prices, at the same time, are approaching the $1,000 mark. Oil and gold are up nearly 10% and 20% this year respectively. Similar scenarios have played out in other commodities, from wheat to coal.

A weaker dollar increases the purchasing power of buyers holding other currencies, giving them the means to bid up commodities like oil. It forces investors to look for other assets, such as gold or grains, to protect against falling real values in stocks or real estate. The weaker greenback also eats into dollar revenues of oil producers and could prompt them to curtail production, thus adding more upward pressures on oil.

"In the short run, the dollar's devaluation increases speculation," said A.F. Alhajji, a professor who specializes in energy at Ohio Northern University. "In the long run, a weak dollar increases demand and decreases supply."

The circle of the weak dollar and rising oil prices could even reinforce itself. When oil prices increase, oil producing countries accumulate large financial surpluses. Part of these surpluses are recycled into the world financial markets, with some ending up in oil futures.

"In other words, some of the oil revenues are being used to buy oil futures and bid oil prices up," Alhajji said.

With inflation at their backs and equity markets slumping, investment funds have rushed into the oil market recently.

Recent data from futures regulators showed speculation in the oil market is increasing. Investors have turned to commodities as a safe haven from slumping equity markets and inflation, which is partly fed by the weaker dollar.

Government data showed speculators and managers of large investment funds, those who don't need physical oil, dominated bets on rising oil prices. Refiners and other oil users were betting oil prices would move lower.

The latest data from U.S. Commodity Futures Trading Commission showed long positions from speculators, in which investors expect oil prices to move higher, outnumbered short positions, or bets on lower prices, by nearly 100,000 contracts last week. Net long positions more than tripled in one month.

This was the fourth consecutive week marking an increase in net long positions from financial traders.

Refiners and other oil users, however, have been betting oil will move lower. Short positions from commercial traders outnumbered long positions by 102,835.

Exxon Mobil Corp. CEO Rex Tillerson said last Wednesday the record run in oil prices was related more to speculation and a weakening dollar than supply and demand in the market.
See full story.

"It's pretty crazy," Tillerson said at a press conference at the New York Stock Exchange after oil hit a new high. A weak dollar accounts for about a third of the recent record run in oil prices, another third on geopolitical uncertainty and the rest on market speculation, he said.

Abandoning the dollar?

The sliding dollar has also renewed talks that the Organization of Petroleum Exporting Countries may consider abandoning the dollar and price oil in other currencies, such as the euro. Such an event, while unlikely anytime soon, would further weigh on the dollar.

The United Arab Emirates' central bank has set up a committee to study a possible depegging of the dirham from the greenback, according to a report by Zawya Dow Jones on Monday. This committee will help coordinate any delinking of the dirham and is expected to report its finding at the end of the year, the report said. Any move toward delinking might pressure other countries in the Middle East to follow suit. See Emerging Markets Report.

OPEC Secretary-General Abdullah al-Badri, an official from Libya, last month said, "Maybe we can price the oil in the euro. It can be done, but it will take time," according to the London-based Middle East Economic Digest.

Such a dramatic change, however, is very unlikely at least in the short term, analysts said.

"The talk is triggered by some of the more anti-U.S. countries in OPEC," said Win Thin, a currency analyst at Brown Brothers Harriman & Co. "The linchpin is Saudi Arabia. If they are still on board, it's hard to see any kind of big shift in policies."

Saudi Arabia, the world's biggest oil producer and exporter, has been resisting the idea of abandoning the dollar.

But the dollar's slide dollar has increasingly raised inflation concerns in countries whose currencies are pegged to the dollar. As the Fed has repeatedly slashed interest rates, those countries were forced to follow suit even when their own economic conditions call for a tight monetary policy. Some Persian Gulf countries have seen record high inflation recently.

Former Fed chairman Alan Greenspan said last month that inflation in some Gulf countries would fall "significantly" if the oil producers drop their dollar pegs, according to media reports.

However, at a recent meeting, the Gulf Cooperation Council, consisting of United Arab Emirates, Qatar, Kuwait, Bahrain, Saudi Arabia, and Oman, rejected the notion of decoupling their currencies from the dollar.

"The dollar has to fall another 20% before they think about changing the peg," Thin said. "If anything, they could repeg the currencies at a different level, but I don't think they are going to abandon the peg."

For major oil producers, abandoning the peg or the dollar denomination could backfire, as it will pummel the greenback and make their dollar reserves less valuable, analysts noted.

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