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Schork Oil Outlook: How High Can Crude Go? Watch Dollar

Since August 24th (52 sessions), spot Nymex crude oil has rallied 14.7% (rolling contracts). At the same time, the U.S. dollar has dropped by around 10.9% against the euro and is now sputtering towards the January lows. However, with the Fed deciding to purchase another $600 billion of U.S. government debt ($100 billion above the market consensus), the question is, how much lower can the dollar go? In other words, how much higher can crude oil go?

As discussed in today’s issue of The Schork Report, the most recent high for the €/$ cross was 1.514 last November. Yesterday the cross traded around 1.410. So there is still considerable room for further dollar weakness. Beyond here the record is 1.6038 which was posted on July 15th, 2008… four days after the Nymex oil bubbled peaked at 147.27. Coincidence? Not bloody likely.

For instance, on July 15th Nymex crude oil traded at 138.74 and the €/$ cross was 1.591. The correlation coefficient (120-day) was a solid 0.751 and the coefficient of determination (R2) was 0.565, i.e. 57% of the move in oil could be explained by the €/$ cross.

However, four months later, November 20th, both crude oil and the €/$ had cratered with the former dropping by 64% to 49.42 and the latter by 22% to 1.245. By then the correlation coefficient had risen to 0.874 (not perfect, but pretty damn solid) and R2 was up to 0.764. Thus, 76% of the selloff in oil could be explained by the drop in the euro. Now fast forward to last night, the long-term correlation (120-day) was 0.792 and the medium-term (60-day) was 0.923, again not perfect, but close enough for government work. In other words, as the euro rises (or as the dollar falls) oil rises.

We would like to fade the recent run in oil, but we’re not. Yesterday the spot December contract spiked to an 85.36 high in the post-DOE spasm, but then quickly jumped back below 85.00 moments later. The bulk of the session was centered in between 84.65 and 84.38. Thus, despite the spike to 85.36, the market finished towards this range.

More importantly, the bulls failed to maintain momentum above the 62% retracement at 85.12 (03-May to 25-May). Nevertheless, oil is going to go in whichever direction the euro goes. Thus, if the euro moves higher (i.e. dollar moves lower) as a result of QE2 then crude oil moves higher. In this vein, despite yesterday’s weak close on the Nymex, the market is trading back above the 62% retracement as of the time of this writing (Wednesday 11pm ET).

Bottom line, if oil is back to $100 by year’s end then we suspect Ben Bernanke will receive a nice gift under the tree from OPEC.

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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.

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