Short Oil: USD strength will drive oil down

Over the past six months, the leveraged rise of oil prices has been largely been explained by the drop in the USD despite over two years of continuous slide in demand for oil.






Yet over the last two months the USD has started to shoot up and oil has mildly corrected in kind.







... despite reports of excessive inventory. In fact, some traders are still optimistic regarding oil in the face of these bearish indicators.

Marketwatch reports ...



"The Greek bailout is helping support global markets and the price of oil," [Mike Sander, investment adviser at Sander Capital in Seattle] said. "If Greece was leaning further along to a default, then we would have seen oil break $70 for sure."

The inverse relationship between crude prices and the U.S. dollar has decoupled over the past three sessions, which may continue if the stock market stays strong, said Jim Ritterbusch, president of Ritterbusch & Associates, in a note to investors.

A large build in U.S. oil stockpiles may also be overshadowed by developments regarding the European Union's plan to address Greece's debt issues, he said. "We expect wide price swings in both directions going forward as an unusual crosscurrent of financial guidance will occasionally be butting heads with bearish underlying oil fundamentals."


To think that data from three trading sessions identifies the decoupling of a year long trend is a little far fetched.

But as far as the Greece debt bomb destroying the price of oil, I highly doubt Greece will default either. It is not in the interest of anyone with real money that they do default. But as soon as Greece gets their bailout package, the other PIIGS will come to the trough. The question is not if one can be bailed out, but will all of the countries with debt solvency issues be bailed out. This fear will be enough to drive the market to the USD and put longer term pressure on oil.

Even without a crisis in the making, forecasts for oil consumption are not strong. Whether it is demand fundamentals or technical factors, both provide tremendous demand for the USD that makes the price of oil in USD look very expensive.

This disconnect cannot stand. Oil will correct in correspondence with the new demand for the USD.

The author is short oil by going long SCO April $16 calls purchased at $1.40.

[Oil demand chart in the US]

Is it time for the USD to show some muscle?

The US dollar has been kicked, spit on, and left for dead in 2009. Gold bugs, fiscal conservatives, and doomsayers all have abandoned the US currency in anticipation of economic meltdown due to the massive amount of debt spending to slow the crisis.

But have USD critics gotten ahead of themselves?

* Oil has overshot against the USD

Since March, USD has fallen less than 20% vs the Euro, but oil futures have increased 40% in anticipation of a collapse in the purchasing power of the USD. Yet that has not happened...

...and as time ticks by, the disparity between the increasing inventory of oil in the market and the demand on the exchanges becomes more and more peculiar.

* Even weaker currencies have gained 30% vs USD

Emerging market currencies such as the Colombian Peso, Brazilian Real, and Turkish Lira all have gained over 25% vs the USD in a just six months. Although their futures are bright, there are still significant political risk to emerging countries that is now disregarded in the purchase price.

* Lots of deflation on the horizon

The market has been bearish on the USD since March. But considering the wind down of stimulus in the next few months (Treasury purchases, MBS purchases, Cash for Clunkers) and also housing programs (HAMP, Housing Tax Credit), the deflation of reduced economic activity should be significantly bullish for the USD.

* USD is reaching historical support levels

Emerging economies need the USD propped up to maintain exports and keep the flow of hard currency into their country. This historical chart underscores the importance of the US economy to the world.



* Traders have moved to a net long position on the USD

In fact, it has been noted recently that traders have switched to a net bullish dollar position.(1)

* USD reversal could cause market mayhem

Many journalists remark on how the investment banks borrow from the Fed for free and invest in other currencies to obtain a spread. This is called a carry trade and it has helped banks such as Goldman Sachs, Morgan Stanley and JP Morgan book billions during this year. Roubini thinks an uptick in the US dollar will lead to a massive carry trade unwind.

“Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”(2)

The author of this blog thinks it is time for the USD to correct, but that it is too risky to play for a major spike in the USD. In the case there were unforeseen banking issues in Europe or in a significant emerging market, a run to the USD could be damaging to US banks who are leveraging USD.

The author recommends buying SCO under $13 and exiting above $15.5

(1) Forbes.com, "Stronger Buck Threatens Stocks And Commodities", Ryan Campbell, Nov 3, 2009

(2) Bloomberg.com, "Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble", Michael Patterson, Oct 27, 2009