Why The Dollar's Weakness Is Good News For Oil Investors

Is it speculation that has driven the oil price above $90 overnight, or is there something more fundamental happening..?

Well, as I have argued many times here before, I believe that the oil price will rise over the medium term due to fundamental factors. However, the major driver that has pushed WTI futures over $90 and gold to a 28-year high is much more simple that supply and demand. It is a basic human emotion. That emotion is fear…

Investors are scared. They have been moving away from assets that are now seen as risky after profligate and stupid lending in the US prompted a credit crunch. Investors, both private and institutional have therefore been seeking safety.

A Reuters' poll of 15 US-based fund management firms showed that their allocation to alternative investments such as commodities jumped from 1% percent in August to 3.2% in September. That is a significant move.

So, does the flow of all this hot money mean that the price of oil is set to retreat? After all, these speculative flows of cash are not unlimited. Surely these gains will be at least partially unwound after the main flow dries up?

The main driver is the dollar

The flight to safety is not the only thing that has boosted oil futures and the gold price. The change in asset allocation from fund managers and conservative investors is part of the story. The dollar is the major driver.

The dollar has been on the slide after the sub-prime crisis put US interest rates on a downward track. This means that oil futures and commodities such as gold and oil futures, which are priced in dollars, look more attractive to investors outside the US. They get more for their money – just like you will if you go on a shopping trip to New York this Christmas. This has been the major factor driving the rise in gold and oil.

Weak manufacturing data yesterday released by the Philly Fed and a terrible set of results from Bank of America are all adding to the view that there will be another US rate cut. This implies yet more weakness in the dollar ahead. This will only increase the flows of this speculation cash into oil futures and gold. The tap will not be turned off for some time yet.

Also adding to the downbeat tone is speculation that Saudi Arabia may end its peg to the dollar or revalue its currency. This speculation increased after Saudi Arabia decided not to follow the Fed’s last rate cut.

Just this week a leading Saudi financial analyst called for a change of strategy. He argued that the currency should be revalued against the dollar, but not de-pegged.

Dr Abdul Wahab Abu Dahesh said the exchange rate should be returned to its 1986 value of 3.65 against the dollar. It is currently 3.75. He said that the plunge was down to a weakness in the US economy and that there was no such weakness in Saudi Arabia.

US treasuries looking vulnerable

There’s also concern that foreign governments, which own a significant amount of US debt, may start to sell these assets should significant falls in the currency continue.

China is already posturing. It is using its power over the dollar as a bargaining chip in its current trade dispute with the US. It has hinted that it may liquidate its massive US treasury holdings if Washington imposes trade sanctions to force a yuan revaluation. The Daily Telegraph called this its “nuclear option”.

Of course, should China start selling US treasuries a collapse of the US currency will become self-fulfilling. The largest holder of US treasuries is Japan. If China starts to sell these assets you can bet your bottom dollar that its central bank will follow suit – and many of the other countries that are holding these assets will do too. The implications for the dollar could be very serious indeed.

Indeed, concern in Japan appears to be building. Japan's ex-finance minister Eisuke Sakakibara said in an interview on Thursday that he thought the dollar may plunge in 2008. He argued that US economic growth may slow to less than 1% next year, as the unwinding of the troubles in the mortgage industry dampen public spending as a whole.

So, the outlook for the dollar is not good. This is positive for commodity prices and for mining companies and oil groups. Just the type of companies I cover in my Outstanding Investments newsletter. It looks like we are going to have some fun – and profitable - times ahead…