What's Ahead for Commodities

If the U.S. dollar stabilizes, some analysts think the oil market will focus on supply and demand again and prices could drop. The outlook for metals is mixed

By David Bogoslaw

The most recent surge in commodities has been tied to the weakening U.S. dollar, which makes dollar-denominated commodities more affordable, and improved economic conditions, which reignites concerns about rising inflation. Oil prices jumped more than 10% in little more than a week, getting another lift on Aug. 21 as the dollar lost some ground to the euro on strong economic reports out of France and Germany.

But determining whether to bet on commodities now calls for some careful disentangling of conflicting economic signals.

China has been the most important driver of global commodities demand over the past 10 years. Some analysts worry that China will rein in the massive economic stimulus it has deployed to counter the worldwide recession to prevent an economic bubble from developing. The government has cracked down on mortgage lending standards and now plans to tighten capital requirements for banks, which could reduce other types of lending.

Meanwhile, improving auto sales in the U.S., thanks to the success of the cash-for-clunkers program, and further strength in the housing market suggest the economy is getting ready to expand, which would boost demand for oil and other commodities.

The Dollar's Influence on Oil's Outlook

Phil Flynn, an energy analyst at PFGBEST, a nonclearing U.S. futures commission merchant in Chicago, attributes the runup in oil prices from the lows of $30-$40 per barrel earlier this year to government stimulus programs in China and elsewhere. He believes China's stimulus program caused it to import "a record amount of oil" in the last couple of months, with some of the oil going unused amid a decline in industrial production. He expects China to remove some of its stimulus and, once that happens, he predicts oil prices will fall due to oversupply, at least in the short term.

However, some analysts believe sentiment toward the dollar will have more influence on crude oil prices than China. Unhappy about the ballooning of the Federal Reserve's balance sheet and the amount of debt the U.S. has borrowed, many people are betting against the dollar and expressing those bets in the crude oil market, says Paul Smith, chief risk officer at Mobius Risk Group in Houston.

"A lot of people have bought crude on expectations that the dollar will crater," Smith says. But with so many investors betting against the dollar, it will be hard for new capital to come into the market to drive the dollar down further, he says. "That paints a bear picture for commodities in general for the short term." Further positive economic news out of the U.S. or any hint that the Fed might consider hiking interest rates would cause a short-covering rally in the dollar, he predicts.

If the dollar stabilizes, the oil market will be forced to focus on supply and demand again, says Flynn at PFGBEST. U.S. energy inventory numbers are much higher than they were a year ago—up 15.2% for crude, 3.8% for gasoline, and 22.6% for distillates such as home heating oil. Demand, on the other hand, has fallen substantially from last year, down 0.1% for gasoline, 9.1% for distillates, and 13.5% for jet fuel. Flynn expects to see oil prices back below $50 a barrel by the first quarter of 2010.

China's Infrastructure Projects

While China pushes for better-quality mortgage and other kinds of loans, the country will keep boosting its economy in other ways, according to Frank Holmes, commodities fund manager at U.S. Global Investors (GROW). He sees the government continuing to use its strategic dollar reserves to buy physical commodities such as oil and metals that it needs to support ongoing economic growth.

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