Oil ETFs: What if the U.S. Dollar Strengthens?

It's no secret that surging oil prices are hammering consumers. It's also contributing to higher living expenses, also known as, "inflation."

In Fed Chairman Bernanke's speech in Spain this week, he sent a strong message to the world that the Fed would be shifting its focus to rising prices for food and energy. Put another way, the Fed's finished lowering interest rates to ward off a housing-induced recession; rather, they will look to keep the economy stable by monitoring the increasing costs of living.

It is doubtful that the Fed can directly reduce the supply and demand of commodities like food, metals and oil; that said, stabilizing interest rates increases faith in the U.S. dollar. (Read more about the fate of the U.S. dollar here.)

Indeed, the dollar has been stabilizing since the final rate cut by the Fed on April 30. Here is a chart of the PowerShares DB US Dollar Index Bullish Fund (UUP) since the last Fed move, compared against the CurrencyShares Euro Trust (FXE) and the PowerShares DB Agriculture Fund (DBA).

Indeed, one can draw a line straight through the middle. Since the dollar has flattened, it is faring well against the Euro and food.

However, oil has risen yet another 10% since April 30. This suggests that, while there is a relationship between the price of oil and the dollar, it is not the only relationship. Speculation vis-a-vis Goldman's $200 barrel call and Pickens' $150 call plays a part. What's more, genuine supply and demand have played a huge role in the run from $40-$50 to $135+.

Steve Liesman of CNBC recently pointed the supply-and-demand fact out with a statistic that showed the price of oil doubling in places like Europe, as it has tripled in the U.S. Of course, that's when Rick Santelli of CNBC counter-punched, pointing out that a 200% rise in parts of Europe compared to a 300% rise domestically suggests roughly a third of oil's rise may be dollar-induced.

Clearly, there is a relationship between the value of the U.S. dollar and oil prices. Worldwide, crude has been priced in U.S. Dollars for 3 1/2 decades. So when the dollar falls, oil prices rise via a phenomenon that many dub, "petrodollar inflation."

Now comes the interesting part. Recently, governments around the globe that had been keeping fuel prices artificially low have been allowing them to rise gradually. This saps oil demand. Higher prices have already been siphoning off demand. Meanwhile, OECD inventories and increased OPEC production suggest greater supply. With supplies rising, and short-term demand falling, the only thing to push Oil ETFs higher are rampant speculators and a weak dollar.

Enter a more stable U.S. dollar, or even a strengthening dollar. Now the only thing to keep egging the oil boom on in the near-term is the desire of speculators to make money on the long side.

Don't bet the farm. Granted, the world will not move to transitional and alternative energies overnight. Even a practical 5-7 year assessment on oil may be one in which prices are still elevated.

In the near-term, however, one should be prepared for the possibility of a dramatic pullback. With magazine covers like the Economist featuring a picture of a stamped barrel ($135), and with CNBC putting a special ticker of crude in the lower-hand corner of its screen for 24/7 viewing, one is reminded of Nasdaq coverage in 1999.

If you're long the United States Oil Fund (USO), keep your stop-losses in place. If you see the potential for a 40% pullback, similar to the one that occurred in 2006, you might be aggressive with ProShares UltraShort Oil (DUG). But that's an ultra-speculative play requiring stop-loss protection as well.

In truth, if the dollar strengthens, it could mean trouble for "commodities-can-only-go-up" investors. Time to take off the blinders.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[Bill Luby]

Nicely said, Gary.

It will indeed be interesting to see how much of pullback we get -- and what sort of effect that has, if any, on attitudes toward alternative energy sources.

Cheers,

-Bill