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Economic factors whiplash energy prices

Sam Fletcher
Senior Writer

The January crude contract for US light, sweet crudes climbed to $94.85/bbl Dec. 12 on the New York Mercantile Exchange before closing at $94.39/bbl, up $4.37 in the biggest 1-day gain since Jan. 30 and the highest closing since Nov. 27, after the US Federal Reserve said it would make $24 billion available to European central banks to spur economic growth.

Goldman Sachs Group Inc., the world's largest securities firm, raised its 2008 oil price prediction to $95/bbl from $85/bbl for benchmark US crude and predicted crude may hit $105/bbl before 2009. Analysts figure higher investment costs and weaker demand will cause producers to curtail supply.

However, the January NYMEX contract fell to $92.25/bbl Dec. 13 then slipped to $91.27/bbl Dec. 14 in a combination of profit-taking and renewed concern about an economic slowdown.

The Department of Labor said US consumer prices jumped 0.8% in November, the biggest increase in more than 2 years driven by higher energy costs. Meanwhile, the US dollar rose to a 7-week high Dec. 14 after earlier plumbing record lows against other key currencies. As a result, crude is not only challenging gold as a financial hedge against inflation but is now also challenging it as a hedge against the dollar's weakness, said analysts with the Societe Generale Group in Paris.

Financial market outlook
"Historically, the correlation between the oil price and the US dollar has always been weak," SGG reported in its December commodities review. However, it said, "Since the start of 2007, this correlation, and more precisely the euro and US dollar vs. the oil price, has increased to reach a record high recently. While a weakening of the US dollar gives a natural incentive to European and Asian oil consumers to hedge more to capture this foreign exchange effect, we are convinced that this traditional relationship does not suffice to explain the recent surge in the correlation."

The foreign exchange (forex) market for international currencies is the largest financial market in the world, trading more than $3 trillion/day. The higher the price of oil, the more US dollar reserves are accumulated by central banks and sovereign wealth funds that manage national investments of oil exporting countries. A weak dollar gives foreign oil producing countries more incentive to exchange it for other currencies to diversify their exposure in both forex reserves and investments.

But now that the correlation has become so obvious, SGG analysts said, "The causality may have been reversed for the last few months, with some investors trading it exactly the same way they have traded the gold and dollar correlation." They said. "While gold has confirmed its status as the best hedge against US dollar depreciation, it is facing stiff competition as the best hedge against inflationary pressure. This results from the perception that the current inflation trend is fueled by commodity price increases, in particular energy and food prices. This would explain why gold, oil, and grains have performed so well since October while base metals, US natural gas, and other soft commodities have underperformed."

SGG "does not expect the subprime crisis fears to recede significantly before the second half of 2008, opening then the door to rate hikes on both side of the Atlantic. Not only should this return to more restrictive monetary policies temper inflation pressures but it should also trigger a trend reversal in the US dollar. In short, the financial outlook is expected to remain favorable for commodities until the third quarter of 2008, which partly explains our more pronounced bearish price forecasts for the second half."

SGG analysts foresee a slight decrease in oil demand within the Organization for Economic Cooperation and Development, with growth coming primarily from China and the Middle East. The increase in the marginal cost of crude production has been "spectacular over the last 5 years" but should moderate over the next 5 as shortages of staff and equipment ease. Analysts at SGG said, "The key feature for 2008 should be the strengthening of the linkage between the US and European natural gas markets. Indeed, while LNG still represents a small component of US supply, it is about to represent the marginal molecule driving the price discovery mechanism on both sides of the Atlantic. However, US natural gas is potentially the commodity that could suffer the most from the subprime crisis and its impact on the US economy, and we therefore see Henry Hub, Okla., [gas spot market] prices averaging the same level as in 2007 ($7.10/MMbtu)."

Market Journal will appear online next on Dec. 31, 2007.

(Online Dec. 17, 2007; author's e-mail: samf@ogjonline.com)



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