May 3, 2016

Why Gold and Oil are Rising and Why it may not be Sustainable

Ever since hitting a low of $25 in Febuary, oil price has been rallying to the recent high of $45. There has been a number of negative news that rightfully could have derailed the rally in oil price. The most significant one is perhaps the fallout among the OPEC members at the Doha meeting by major oil producers around the world including Russia. The objective of the meeting is to halt oil production growth and put a stop to the oversupply of oil inventories, thus reversing the fall in oil prices which has been hurting many oil dependent countries. However, the refusal by Iran to attend the Doha meeting, an arch enemy of Saudi Arabia, resulted in Saudi Arabia refusing to participate in the production halt even though many other oil producers which include Russia have agreed to the terms.  Without Saudi Arabia, which is one the largest oil producer in the world, the Doha talks fell apart and everybody in the world watch in anticipation that oil prices will take a hit.

However, oil price held their ground and did not fall below $40.

There are two main reasons which I see why oil price is holding their ground right now.

1) The initial fall to $25 for oil price has over shot it's actual supply and demand equilibrium as what I have described in my article a few months back. Market is always irrational and tend to swing towards extreme pessimism or optimism  and $40 is probably the equilibrium price at this moment in time.

2) The USD continues their relentless fall even without clear indication from the US Federal Reserves on the direction of interest rates. The fall in USD supports commodity prices in general and this may have supported the price of oil in the face of adverse news.

On the Gold frontier, the rally continues as USD continues to weaken across all major currencies. Without any actions from both EU Central Bank and the Bank of Japan, Gold speculators are emboldened by the fact that USD may remain weak and continue to add to their position. The positive economic data coming from China has also boosted the confidence of the commodity prices after a steroid injection in both the fiscal and monetary front.

Both commodity prices have been supported by a weak dollar and should the dollar starts to strengthen again, one of the key support of 2 of the best performing asset classes in April will suddenly be removed. Given that financial markets tend to overshoot itself, the fall in USD may has overshot its equilibrium and it may rally back in the near future. Also, the matter of whether China is going for a hard or soft landing has not been resolved yet as investors are waiting to see if the recent boost in the economy will be able to sustain over a longer period of time given that the Chinese economy has a long term structural issue which will take years to adjust. A hard landing scenario is still possible given the tightrope that the Chinese government has to walk and a hard landing in the Chinese economy will have a negative impact on oil as what we have seen in the past 1 year. Gold prices will probably take a tumble as the more exposed and weaker European ans Asian economies will engage in aggressive monetary policies to offset the impact of a China hard landing, resulting in an indirect rise in USD, especially against Asian currencies. A relatively strong USD against a basket of currencies is always bad news for gold.

So if you are looking to going back into commodity investing again, the winds seem to favor gold as of now. However, given that gold and oil prices have rallied significantly, perhaps it is time to look at the asset class that has been recently bashed down quite a bit: The US Dollar.

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