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Schork Oil Outlook: Dollar-Oil Decoupling? Wrong!

A Duel to the Debt Concerns...

Yesterday’s issue of The Schork Reportstated that “Pundits are now beginning to raise the specter of ‘decoupling,’ where a higher dollar moves in line with commodity prices. We’re not falling for it.”

Yesterday, the dollar rose 1.00% while WTI fell by 0.39%. In afterhours electronic trading WTI fared even worse, at one point dropping down below the 85.50 mark.

There are two main reasons why the dollar and crude oil move in opposite directions:

Firstly, crude is a dollar denominated commodity. By the laws of economics 101, a weaker dollar makes crude oil cheaper for refiners buying in foreign currencies. As the price drops, these refiners can buy more barrels of crude oil, pushing up demand. Higher demand leads to higher prices and the value of crude rises in dollar terms. Conversely, a stronger dollar means crude oil is now more expensive. This reduces demand from refiners, and a lack of buyers leads to lower prices.

Secondly, the commodities complex functions as a lifeboat when traders are concerned about future strength in the dollar. Investors are likely to pull their money out of T-bills and in to (for instance) the USO, which then purchases crude oil futures.

The net effect of this is clear, as demonstrated by the correlation co-efficient of -0.903 and the Chart of the Day, where crude oil fell as the dollar rose in an almost mirror-image pattern. The question now is whether the dollar will rise or fall.

From a fundamental perspective, the dollar has been weakening against the euro, hitting a recent low of €0.704. However, the euro is hardly the picture of strength as traders continue to focus on Irish debt woes. The dollar-yen relationship has recovered to 81.60 yen amidst rumors that China is not through dumping its yen reserves (recall the summer’s spending spree as China bought yen through July at a record pace).

At the same time, the CME increased its silver margins from $5,000 to $6,500 yesterday, which led to a sell-off in the silver funds and futures. A higher cost of entry results in fewer return opportunities. Traders may now look to pull money out of silver and back in to the dollar.

The bottom line is that the dollar-crude relationship is nigh-irrefutable. If the dollar begins to rally, we would feel extremely uncomfortable buying into crude, especially at levels above $87.00.

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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.