Dollar Drops, Oil Rises As Inflation Hedging Drives Market


After a dismal showing yesterday, oil rallied Tuesday, gaining nearly 3% on the New York Mercantile Exchange. Bolstered by the largest drop in the value of the US dollar against the euro in the last six weeks, oil spiked more than $2 in trading today.

The dollar fell 1.6% to $1.409 per euro on the assumption that the Federal Reserve will dilute any increase in the interest rate this year in an effort to decrease the cost of borrowing money.

Crude oil for August delivery settled Tuesday at $69.24 a barrel on the NYMEX, up $2.31 from Monday's close. London's Brent crude jumped $1.83 to $68.81 a barrel on ICE Futures. Natural gas experienced slight losses today on the NYMEX, closing at $3.879, or .054 cents lower.

"Oil has almost become an innocent bystander in all this," said Bill O'Grady, chief market strategist at investment advisory firm Confluence Investment Management LLC in St. Louis. "One of the things I'm very careful about telling people these days is: It's not supply and demand; it's supply and consumption. Supply and consumption fundamentals are frankly pretty bad."

Nonetheless, the financial demand for oil is strong, he continued. Investors have begun buying commodities, such as oil, as a protection against inflation, a way to diversify their portfolios.

"But oil has become, and all commodities have to a greater or lesser extent, financial products or asset classes," O'Grady added. "The demand for oil is actually pretty strong, but it's not from consumption, it's from investment demand. To some extent it's a form of financial hording."

Furthermore, O'Grady contends that this inflationary hedging is not just being done by US investors, but that foreign investors -- particularly the Chinese -- are participating in this practice, as well. In an effort to diversify their foreign reserves, the Chinese have been "stockpiling" commodities.

"We had a great thing going for a number of years where the Chinese would send us stuff, and we would send them pieces of paper back," O'Grady said. "Now the Chinese have figured out that we can manipulate the value of that paper unilaterally, and there's really nothing they can do to stop it. So to protect themselves, they're using these dollars to buy commodities."

Overall, O'Grady pointed to fear as a controlling factor in the commodities markets.

"It's basically fear of future inflation, due to the stimulation policies this administration has put in place," he said. "It is having a positive impact on the entire commodity complex."

Conversely, natural gas has not seen the gains that crude oil has because of its domestic nature and its delivery method.

"Interestingly, natural gas almost proves the point of the financial demand," continued O'Grady. "There aren't very many regional commodities that we trade. Most are global, some more global than others. Natural gas is almost entirely regional, because of the way it's transported. If I'm China, and I'm trying to diversify my foreign reserves by owning commodities in lieu of owning US financial assets, owning natural gas doesn't do me any good because I can't get it delivered from the Henry Hub."

Although he admits that liquefied natural gas will change the playing field for natural gas in the future, O'Grady doesn't feel that the percentage of the market that LNG commands currently affects the global supply structure.

"It's interesting that the less global a commodity is, the weaker the performance has been for the last several months," he concluded. "If you look at the relationship between natural gas and oil, it's clearly an unusually extreme level. My hunch is that it's being driven by the fact that there are a lot more financial flows that go into oil than go into gas, due to the nature of its delivery and its degree of globalization."


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