This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.

Last Friday, US crude oil futures finished above $78, the highest level in a year, surging more than 9% during the past week making it the largest weekly gain since the height of the summer driving season, even though the US continues to sit on ample supply of petroleum.

Given the continued sluggishness of the economy, high unemployment rate and large amounts of excess oil production capacity around the world, analysts said a sudden upward spike was still unlikely, while others are predicting an immanent correction down below $70.

However, if you take a closer look, it is evident that the current crude oil market is almost entirely detached from fundamentals. Furthermore, there are several factors supporting oil rising to new levels, as fundamentals are out the window in the near to medium term.

Technical breakout
Oil has been locked roughly in a band of $65 to $75 a barrel since the start of June as traders weighed optimism over the prospects for a recovery in global demand against a supply glut (see chart below). Typically, the longer it is trading in a sideways pattern, potentially the more powerful a breakout is going to be.


And breakout it did on the first sign of a seemingly positive indication. In addition to dollar weakness, the oil rally last week was sparked also in part by government data that showed surprise inventory drawdowns in domestic gasoline and distillates (mostly due to lower refinery runs at around 81%).

This, coupled with stronger-than-expected China trade data, was enough to send a ripple through the markets midweek boosting market bullish sentiment on global economy recovery hopes along with oil demand.

Now that oil blew past its previous 2009 high of $75, many analysts believe the recent increase is a sign that prices will now trade at a higher range.

US dollar policy … if there is one
The recent rallies in commodities, including crude oil, and even the stock market to some extent, have been driven primarily by the floundering dollar on the lack of fundamental support from the demand side since the recession (see chart below).


The US dollar dropped to a 14-month low against a basket of currencies on speculation the Federal Reserve will keep interest rates low trailing other central banks and the unprecedented levels of government debt. Crude and most commodities are priced in the dollar; therefore, tend to rise when the US currency falls.

Though the correlation between the dollar and oil has not been statistically established, dollar is clearly part of the “causation” of crude movement this year, as investors sold dollars and bought oil as a hedge against inflation and uncertainties in other asset classes.

With a concrete “dollar policy” and “dollar intervention” conspicuously lacking, traders and investors are wondering if US officials merely wanted to slow the rate of decline of the dollar, and that the Administration really does not care if the dollar depreciates, only how fast.

On that note, markets will no doubt keep testing the US dollar resolve, and if government actions do not follow their rhetoric (highly probable from current indications), we could all say good bye to the dollar as it could free fall to no man’s land. And anyone could guess what that would do to the price of oil as well as inflation.

Capital flow & asset rotation
Under normal circumstances, oil prices and stocks typically have an inverse relationship. That is, rising oil prices pressures stocks, and falling stocks push investors into oil.

However, since the recession last year, oil and stocks have been trending in lock step largely due to the huge amounts of easy money freed up by global governments to rebuild their economies and companies.

The stock market is rising with the Dow breaking the 10,000 mark last week, which is an indication that cash in general has come back into the market. In fact, most of the price movement in the crude market is clearly stemming from financial flows based on activities on the NYMEX and ICE.

When there’s so much liquidity in the system, it will have to go somewhere. So, we should still expect crude and stocks to move in tandem, but the rotation of assets has deepened more in hard commodities because of the rising skepticism in equity markets. This means crude oil could outperform equities in the medium term.

Better fundamentals won’t hurt either
Even though fundamentals won’t play a significant part in the oil market for the foreseeable future, any positive data points could further bolster the non-fundamental factors discussed so far.

The International Energy Agency (IEA) did just raise its forecast for global oil demand for the current year and for the next year citing a more optimistic economic prognoses and stronger preliminary data from America and Asia.

Déjà vu year 2008
You may recall the start of the US Federal Reserve’s cycle of interest rate cuts in 2007 spurred the influx of cash into commodities markets. Oil prices surged during the period, peaking at a record $147 a barrel in July 2008 as the money flowed in amid projections of strong global demand driven by emerging markets like China.

Right now, the US Dollar is driving the oil price. In order for the trend to change, the US dollar has to strengthen against other currencies, and that is unlikely to happen without some intervention by the US government relative to its current monetary policy.

The dollar has not collapsed but the trend has been downward this year and fear is the trend could continue with massive and growing national debt and quantitative easing policies by the Fed. Until we get any strong change in fundamentals for the dollar, it will continue to weaken further and everyone will flock to crude as one of the primary hedges (gold being the other).

Even though there are ample supplies of petroleum products due to the recession and there is little chance of a shortage in the near term, based on the technical and dollar indicators, it is likely that the next technical breakout would move crude oil to the $85 level. While some option bets of $100 crude by the end of 2009 seem overly aggressive; nevertheless, crude could trade above $100 within 12 months based purely on non-fundamental factors.

Bubbles will deflate
Investors should expect crude oil to be much higher during the heat of 2010’s summer driving seasonal run-up, with the peak price probably well above $110 at this pace sometime by next July, before the Fed is pressured to curb high commodity prices by raising rates.

The Administration will face a considerable dilemma with both a high unemployment rate and sky high gas prices at the pump from the oil run-up due to a weak dollar policy. The unemployment will not be magically solved by itself, the easier solution would be to raise rates to curb commodity inflation.  But by the time the public is up in arms about high gas prices, it is too late, the inflationary damage is done.

So once again, we have managed to create yet another bubble in asset prices. Until we have a longer term view for monetary policy, expect asset bubbles to continue, and invest accordingly to prepare for the eventual and inevitable deflate.

Source: Dian Chu, Economic Forecasts & Opinions, October 18, 2009.

* Dian Chu is a market analyst, trader and financial writer for Zero Hedge, Seeking Alpha and Daily Markets. Her articles are also syndicated to Reuters, USA Today and BusinessWeek. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. She is currently working in the US in the energy sector.

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