ETFs: Dollar Damage

There is an old saying that chartists have: The trend will continue until it ends. Yes, it seems silly, even stupid. But, if you are a technician — trying to divine future prices from past price movements and trading volume — that saying is probably making a lot of sense right now.

Indeed, oil futures' moves since mid-summer have been downright wild. Just as many advisors finally got their most reticent clients positioned with some commodity exposure, the bottom seems to have fallen out of the oil market. And as oil goes, so, for the most part, go commodity indexes.

Crude oil is the largest single component of the Dow Jones-AIG Commodity Index, and comprises more than half of the S&P/Goldman Sachs Commodity Index. That makes exchange-traded vehicles based upon these benchmarks, in essence, oil proxies.

Oil took only a month to retrace three-quarters of its April-to-June price gains, prompting advisors and their clients to wonder if the commodity bubble had burst, or if the weakness was merely a correction in a secular bull market. (Oil prices have dropped by $30, or 21 percent, since hitting a record $147.27 on July 11 — putting oil firmly into bear market territory.)

So, do you sell? Or add more commodity ETFs and ETNs to your clients' positions? It's best to recall what propelled oil prices higher in the first place. If the fundamental generators are still whirling in the background, it's likely that oil and the commodities complex could surge again.

The Law Of Supply And Demand

Most pundits offer up supply and demand forces as the primary drivers for the appreciation in oil prices. The U.S. is the world's most profligate oil consumer, sucking up a quarter of the global supply. Lately, though, emerging economies — notably China, India and the Middle East — are increasingly driving demand. Nearly 60 percent of the growth in oil consumption over the past half-dozen years arose in these three markets. Over that time, in China alone, passenger car sales increased more than fivefold, indicating the country's rising level of consumer demand.

As crude oil and distillate prices have risen, we've seen little demand destruction domestically. The U.S. thirst for motor fuels is off but two or three percent over the last year. The genie is out of the bottle in China, too, so demand for oil and distillates, will, in all probability, continue to grow — even if the U.S. slides into recession. Personal consumption accounts for 37 percent of Chinese gross domestic product, while exports make up 27 percent. A U.S. recession, it has been suggested, would mean a wholesale slowdown in demand for Chinese goods, but the figures suggest that Chinese consumers are more likely to be the engines of GDP growth than non-Chinese consumers.

On the supply side, a new refinery hasn't been built in the U.S. since 1976. Our oil infrastructure is old and inefficient. Domestic oil inventories, in fact, have been in decline since the mid-1980s. In the past year alone, stocks outside the Strategic Petroleum Reserve have fallen by 57.5 million barrels, or 16.2 percent.

This situation is unlikely to change any time soon. It takes time to build out infrastructure and the costs are enormous. Which oil company is likely to want to make such an investment while feeling the squeeze on its refining margins? A year ago, the profit margin available for cracking crude into gasoline and heating oil was 13 percent. It's now half that. In sum, the supply and demand picture seems little changed, and it seems unlikely that it will radically alter in the near term.

So what's different now? Why have oil prices swooned so suddenly? The answer to that can be found in your wallet: It's the strengthening dollar.

The Stronger Dollar Effect

Worldwide, oil trading is conducted in greenbacks. Over the past few years, the Bush Administration has talked up a strong dollar while allowing the Federal Reserve to flood the world with our currency.

Inflation, boiled down to its essence, represents a loss of purchasing power. If your George Washingtons buy you less food or petrol now than they did a year ago, that's prima facie evidence of inflation.

The effect of the inflationary U.S. monetary policy is best seen through the lens of the currency market. In the past 25 months, the price of West Texas Intermediate crude soared from $70 to $116 a barrel, a 66-percent increase. Price oil in euros, however, and the run-up is a more modest 44 percent. So, yes, oil's price has risen, but the effect of American currency cheapening explains $38 of the $46 oil price hike. It's this factor that now looks to be changing.

Capital is attracted to those currencies offering high yields. In the low-interest world of post-dot.com America, the rates that could be earned on George Washingtons were less appealing than yields offered on other currencies. Take the euro. While our Fed played fast and loose with the dollar, the European Central Bank maintained an unwavering anti-inflationary stance, keeping money tight and rates comparatively high. Capital was thus attracted to the euro. Recently, though, in light of the slackening European economy, currency traders are seeing the handwriting on the wall, and are making bets on a more dovish ECB policy.

In just six weeks this summer, the dollar gained 4.3 percent against the euro. That's significant, considering the preceding depreciation in the U.S. currency averaged 6.3 percent a year. When, and if, the ECB finally faces the music, it may be forced to play catch-up with rather aggressive rate cuts. The resulting enervation of the euro could close the inflationary gap between the currencies and serve as a drag on oil prices. Those are, of course, a lot of ifs.

What Next?

Overall, the supply of oil isn't likely to expand, so demand is the intrinsic variable that will most influence prices. Until alternative energy sources become economically viable, there's likely to be a floor for crude oil. Whether that's $75 a barrel or $100 a barrel remains to be seen. Monetary policy, of course, shifts in shorter cycles.

Times like these require judicious asset allocations. Maintaining some, but not too much, exposure to commodities as a core holding may be the wisest course. Institutional accounts can stomach bolder bets. The Harvard University endowment holds 17 percent of its assets in commodities, the second largest allocation in its portfolio. Studies done by Ibbotson indicate that the optimum level of commodity exposure for a moderate-to-conservative asset allocation and a modest risk tolerance is 20 percent. For many investors, though, that may seem foolhardy. For these folks, a 10 percent allocation may be tops.

GOT OIL EXPOSURE?

Oil exposure varies widely among broad-based ETFs and ETNs.