The oil-dollar link: the Fed, hedge funds, and why oil could hit $150 a barrel.

• Author: Verleger, Jr., Philip K.

The relationship between the dollar's exchange rate and oil prices has been debated now for decades. Oil-exporting countries justified their first round of price hikes to $10 per barrel in late 1973 by blaming global inflation and the falling dollar. Oil-exporting countries again blamed the weakening dollar for the second major round of price increases in 1978. Eight years later, the dollar's resurging value was cited as a cause of the 1986 price decline. More recently, oil prices and the dollar's exchange rate have seemed to move as one.

However, the mechanism that links the movement of oil prices and the dollar has never been satisfactorily explained. Indeed, a credible explanation may never be found. Certainly no one to date has advanced a convincing theory for their coincident movement.

Yet the relationship clearly exists, particularly since 2007, as can be seen from Figure 1. This graph presents the spot price of "Dated Brent," the world's crude oil benchmark, against the left vertical axis and the dollar's exchange rate against the right. To paraphrase Bob Dylan, "You do not need to be an economist to observe the linkage."

Why does one observe this linkage and what does it portend for the future? One way to answer the question would be to construct a detailed econometric causality study. If such efforts were made, I am sure one group of brilliant econometricians would find a causal linkage which showed that oil price movements were caused by changes in the exchange rate while a second equally brilliant group would find the reverse. I do not propose to conduct this kind of examination, although I was once a practicing econometrician. Instead, I suggest that recent coincident movements of oil prices and the dollar's exchange rate reflect declining confidence in the Federal Reserve's ability to contain inflation. Furthermore, I show that the rise in oil prices over the last six months--particularly the surge since January 22, 2008--shares many characteristics with the rise in silver prices that occurred from early 1979 to January 1980. This leads to a very frightening conclusion: oil prices could be pushed to $150 per barrel or higher before the end of 2008.

RECENT OIL PRICE CYCLES

Of late, crude oil prices have followed a relatively predictable cycle over the course of a year. The pattern is similar to the cycle observed in agricultural commodities. Crude prices rise during the spring and summer as gasoline prices exert an upward pull on prices for "light sweet crudes" such as Brent and WTI. These two crudes share two key characteristics. First, they are the benchmarks for trading in futures markets. Second, they have unique chemical characteristics that make them particularly attractive to refiners at times of peak gasoline and diesel fuel consumption. For this reason, prices can be expected to rise in the spring and summer and then decline with the approach of winter as motor fuel use drops. The price decline generally lasts until mid-January.

The cyclical pattern can be observed from Figure 2. This graph shows the daily spot prices for Brent crude ("Dated Brent") from January 2004 through February 29, 2008. Vertical lines mark the price peaks. Note that these occurred in August 2005, August 2005, and August 2007 as expected. The peak in 2004 occurred later, in October.

The price decline from August 2006 to January 2007 was particularly noteworthy. During this period, the emergence of Wall Street commodity investors provided a strong incentive to build stocks (see my piece, "How Wall Street Controls Oil,"...